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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,
Squaring the circle is the challenge of constructing a
square with the same area as a given circle, by using only
a finite number of steps with compass and straightedge.
In 1882, the task was proven to be impossible, as a
consequence of the Lindemann–Weierstrass theorem
which proves that pi (π) is a transcendental, rather than an algebraic
irrational number.
Fortunately, Ms Sabine Lautenschläger, Member of the Executive Board of
the European Central Bank, does not believe that banks must square the
circle. She said:
“Banks are obviously not having an easy time right now. They are obliged to
increase earnings in times of low interest rates and tough competition, but
at the same time must not take any excessive risks when doing so.
Many would liken this to trying to square the circle. I think it's more like a
system of mathematical equations with many unknowns - complicated, but
nevertheless resolvable.”
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My question: Is a system of mathematical equations with many unknowns
resolvable? Is this problem better that trying to square the circle?
It is not resolvable, unless specific conditions are met. You know from high
school that in order to solve any system of linear equations, you must have
the same amount of equations as the amount of variables. If the variables
are more than the equations, we must make assumptions about some
variables, to find the other variables according to these assumptions.
(Unfortunately in banking the variables are always more than the
equations. This is where internal models usually fail to give reasonable
outcomes).
Ms Sabine Lautenschläger, I agree, banks are obviously not having an easy
time right now. They are obliged to increase earnings in times of low
interest rates and tough competition, but at the same time must not take
any excessive risks when doing so. In my opinion, this is a recipe for
disaster, not a system of mathematical equations with many unknowns complicated, but nevertheless resolvable.
There is another very interesting point in this speech:
“As far as the liquidity of small and medium-sized institutions in Germany
is concerned, there isn't really a lot I can say. Instead of there being too little
liquidity, there is too much liquidity in Germany.
And this liquidity is searching for yield.
First and foremost, high capital and liquidity ratios are sound preconditions
for the stability of small and medium-sized institutions.
They are good preconditions for the banking system being able to withstand
unfavourable market conditions or unexpected shocks - even over a
prolonged period.
It is important that these preconditions are met, because small and
medium-sized institutions are facing a series of risks and challenges.
The greatest of these challenges is the banks' business models and earnings
performance.
It's nothing new that some banks in the euro area are suffering from weak
profitability.
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And that's not just since the period of low interest rates began. It was also
the case before that - including for some small and medium-sized
institutions.
In some countries, competition among banks for customers is rife - and it is
an unhealthy form of competition if risks and collateral are not priced in
correctly.
In 2014 banks' return on equity was just over 3%, considerably lower than
what market participants would deem sustainable.”
I agree with these market participants. It is not sustainable. It is a disaster
waiting to happen.
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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International Association of Risk and Compliance Professionals (IARCP)
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Caught in the middle? Small and medium-sized
banks and European banking supervision
Ms Sabine Lautenschläger, Member of the Executive Board
of the European Central Bank and Vice-Chair of the
Supervisory Board of the Single Supervisory Mechanism, at the Banking
Evening of the Deutsche Bundesbank Regional Office in
Baden-Württemberg, Stuttgart
“I also hope to be able to answer some questions and clear up
misunderstandings - regarding, for example, which tasks European
banking supervision, the SSM, does perform and does not perform in
supervising small and medium-sized institutions, as well as those tasks it
does not wish to perform.
Let me start by clearing up one misunderstanding.
Yes, the SSM supervises small and medium-sized institutions only
indirectly - and we have absolutely no desire to directly supervise these
institutions.”
Money markets after liftoff - assessment to date and
the road ahead
Simon M Potter, Executive Vice President of the Markets
Group of the Federal Reserve Bank of New York, at the 70th
Anniversary Celebration of the School of International and Public Affairs at
Columbia University, New York City
“Because of the large size of the Federal Reserve's balance sheet, the staff at
the Federal Reserve spent the past several years developing a new and
innovative framework to control money market rates, and working to
increase the amount of data we receive about trading in those markets.
In my remarks today, I will review the performance of this new framework
and discuss key insights from those new data collections. Before 2008,
bank reserves were scarce, and the Federal Reserve influenced overnight
interest rates by making small adjustments in the supply of reserves.”
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The UK economy post crisis - a series of
unfortunate events?
Sir Jon Cunliffe, Deputy Governor for Financial
Stability of the Bank of England, at the Centre for
International Business Studies, London South Bank
University, London
“There is a well-known myth - much loved in management schools - that if
you put a frog in boiling water it will jump out; but if you put it in cold
water and bring the water very slowly to the boil, its nervous system will
not register the temperature change and it will be boiled.
I am assured by zoologist friends that it is indeed a myth. Frogs sense
gradually changing temperatures like the rest of us. But it is an instructive
parable. Sometimes when you focus on incremental changes you can forget
the big picture until the water has become very hot - or very cold.”
UIC-SEC Joint Symposium to Raise Public Awareness:
Combating Pyramid Schemes and Affinity Frauds Opening
Remarks
Andrew Ceresney, Director, Division of Enforcement
Chicago, IL
“Since many of you may not be particularly familiar with who we are and
what we do, a little background on the SEC is probably in order. At the SEC,
our tripartite mission is to protect investors, maintain fair, orderly, and
efficient markets, and facilitate capital formation.”
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Solvency II implementation - beyond
compliance
Gabriel Bernardino Chairman of the European
Insurance and Occupational Pensions Authority
(EIOPA) at the IVASS Conference 2016 “The Launch of
Solvency II”, Rome
The title chosen for this conference is particularly relevant for EIOPA
because the word “launch” perfectly reflects our current frame of mind.
-
I will start by explaining why this is, and EIOPA’s role in the
implementation of Solvency II.
-
I will then focus on some important challenges related to the
implementation of the new risk-based regime, and what should be done
in order to deliver on the intended objectives of Solvency II.
-
Finally, I will share my views on the post-evaluation process that will
guide us to the Solvency II review.
Raising standards in Malaysia's financial
services industry
Dr Zeti Akhtar Aziz, Governor of the Central Bank of
Malaysia (Bank Negara Malaysia), at the Centre of
Excellence (ACE) Ground Breaking Ceremony, Kuala
Lumpur
“ACE is a very much welcomed industry led initiative to raise the level of
capability and professionalism for the work force in the Malaysian financial
services industry.
Our financial services industry continues to be reshaped and transformed
by several major forces of change that range from the new demands of
consumers and businesses to the rapid advancement in technology, the
global regulatory reforms and the continued globalisation of finance.”
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Trusted Geolocation in the Cloud:
Proof of Concept Implementation
Michael Bartock, Murugiah Souppaya
Raghuram Yeluri, Uttam Shetty
James Greene, Steve Orrin, Hemma Prafullchandra, John McLeese, Jason
Mills, Daniel Carayiannis, Tarik Williams, Karen Scarfone
This publication explains selected security challenges involving
Infrastructure as a Service (IaaS) cloud computing technologies and
geolocation.
It then describes a proof of concept implementation that was designed to
address those challenges.
The publication provides sufficient details about the proof of concept
implementation so that organizations can reproduce it if desired.
The publication is intended to be a blueprint or template that can be used
by the general security community to validate and implement the described
proof of concept implementation.
Economic perspectives
Annual address by Mr Øystein Olsen, Governor of the
Norges Bank (Central Bank of Norway), to the
Supervisory Council of Norges Bank and invited guests,
Oslo
“In late autumn 1857, a steamship left Christiania bound for Hamburg
carrying a cargo of silver from Norges Bank to be deposited in one of
Hamburg’s finance houses.
In only a few months, 20 tonnes of silver worth 800 000 speciedaler were
shipped south as collateral for the redemption into silver of bills and notes
issued by Norges Bank. There was to be no doubt that the speciedaler was
worth its face value in silver.”
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Interest rate benchmarks
Guy Debelle, Assistant Governor (Financial Markets) of
the Reserve Bank of Australia, at the KangaNews Debt
Capital Markets Summit 2016, Sydney
Today I am going to talk again about interest rate
benchmarks, as there have been some important recent developments.
These benchmarks are very much at the heart of the plumbing of the
financial system. They are widely referenced in financial contracts.
For example, the interest rate on a corporate loan is often a spread to an
interest rate benchmark. Many classes of derivative contracts generally are
based on them, as are most asset-backed securities.
Philippines in 2016 - sustaining resilience amid
headwinds
Amando M Tetangco, Jr, Governor of Bangko Sentral
ng Pilipinas (BSP, the central bank of the Philippines),
at the 3rd Business Forum of The Manila Times, Manila
“Very few institutions stand the test of time - technology, innovation, and
more recently, social media, among others; change the way we do things,
how we perceive events, and therefore how we react.
Central banking in the Philippines is just 67 years old and yet the events of
the last two decades have dramatically changed how we do things.
I am sure many, if not all of you, have heard of central banks lowering their
policy rates to negative territory, of quantitative easing (QE), and of
macroprudential measures.
In reality, the central banker's tool box now contains other implements
beyond the traditional interest rate and on-site supervision.”
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Caught in the middle? Small and medium-sized
banks and European banking supervision
Ms Sabine Lautenschläger, Member of the Executive
Board of the European Central Bank and Vice-Chair of
the Supervisory Board of the Single Supervisory
Mechanism, at the Banking Evening of the Deutsche
Bundesbank Regional Office in Baden-Württemberg, Stuttgart
Ladies and gentlemen,
I am delighted to be here in Stuttgart this evening.
On the one hand, because I can honour the promise I gave to the President
of the Bundesbank's Regional Office, Mr Sibold, when I was still
Vice-President of the Bundesbank.
On the other hand, because I am looking forward to the opportunity of a
discussion with you after I have given my speech.
I hope it will be a lively discussion of what you expect from European
banking supervision.
I also hope to be able to answer some questions and clear up
misunderstandings - regarding, for example, which tasks European
banking supervision, the SSM, does perform and does not perform in
supervising small and medium-sized institutions, as well as those tasks it
does not wish to perform.
Let me start by clearing up one misunderstanding.
Yes, the SSM supervises small and medium-sized institutions only
indirectly - and we have absolutely no desire to directly supervise these
institutions.
If an individual small or medium-sized institution fails, it does not
generally jeopardise the stability of either the national or the European
financial market; so it does not need to be subject to European banking
supervision.
Let me briefly put the role of small and medium-sized institutions in the
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euro area into perspective, before I deal with the greatest challenges facing
this group of institutions.
There are roughly 3,300 banking groups in the euro area, 129 of which are
directly supervised by the ECB.
We will leave these few banks out of the picture this evening and devote our
time to the remaining 3,200 or so groups of institutions instead.
And let me start by going straight to the trickiest part: the correct
description of these institutions.
The official term for them is "less significant institutions".
This is because, although they are clearly in the majority, their balance
sheet total is comparatively small.
If we look at the overall balance sheet total of the euro area banking system,
scarcely 18% can be attributed to the "less significant institutions".
Does this mean that small and medium-sized institutions and their services
are completely unimportant and so do not require good supervision?
Not at all!
This 18% of the balance sheet total for the entire euro area banking system
is not evenly spread across all countries, but is essentially concentrated in
three: Germany, Austria and Italy.
These three countries alone are home to four-fifths of all the supposedly
"less significant" institutions, whose balance sheet total amounts to 80% of
annual economic output in Austria and Germany.
And in Germany, it is precisely these institutions that provide funding to
small and medium-sized enterprises, which, in turn, form the bedrock of
the economy.
All in all, the "less significant" institutions in Germany finance 70% of the
regional economy.
I'm therefore not going to discuss at this point whether or not these
institutions are important for the real economy - everyone knows that they
are.
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And everyone knows that the "less significant" institutions can indeed be
significant for the stability of the banking system - not individually, but
collectively as associations of savings banks and cooperative banks.
That is particularly true when you consider that many small and
medium-sized institutions in the euro area belong to institutional
protection schemes and are hence closely interlinked - and often they are
also in protection schemes with large, systemically relevant banks.
I'll come back to this topic later on.
Ladies and gentlemen, at this point, I'm going to have to disappoint one or
two of you: I do not think it is a good idea to leave the "less significant"
banks to regulate themselves or to encourage a form of supervision that is
more akin to gravedigging than supervising, focusing solely on resolvability.
And, the type of supervision being advocated by some, whereby supervision
is exercised over the association rather than over the individual institution,
is also no solution as long as there is no legal basis or tools for the
appropriate, effective and efficient supervision of associations.
For all the reasons I have just mentioned, and I could give many more, the
supervision of "less significant" institutions, which tend to have a regional
focus, needs to take into account national particularities on the one hand
and meet high quality standards on the other hand.
After all, the aim is to have a functioning banking sector over the medium
and long term, providing the real economy with the services that it requires
- and it is precisely small and medium-sized institutions that make for a
functioning banking sector, as clearly highlighted by the financial crisis.
Given the experience of the past year, I believe that indirect supervision, as
is being carried out by the ECB, can be of great benefit - to banks, to their
customers, to the stability of national financial centres and to the real
economy.
But I will come back to that later too.
Now, going back to finding a name for the "less significant" institutions.
How should we refer to these 3,200 banks?
As you've probably noticed by now, I've opted for the term "small and
medium-sized institutions" - and this decision was preceded by a lengthy
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discussion.
For those of you who represent a small or medium-sized bank, I hope that
you are happy with this description; it will see us through the rest of the
evening.
Having now resolved the naming problem, we can turn our attention to
some slightly more straightforward issues.
I will address two topics this evening.
First, the challenges now facing small and medium-sized banks; and
Second, the cooperation between the ECB and the national authorities in
supervising small and medium-sized banks.
The challenges - weak profitability and low interest rates
Whether national or European, supervisors are always interested in banks'
stability.
And the most important components of a stable bank are capital, liquidity
and profitability.
Capital serves as a buffer for losses - the higher it is, the more losses a bank
can absorb before it collapses.
If we want to assess a bank's stability, we should first look at its capital.
The capital ratios of small and medium-sized institutions in the euro area
are gratifying.
The average Tier 1 capital ratio is 15.2%.
In Germany, the Tier 1 capital ratio of this group of institutions is slightly
below average at 14%, but is still significantly above the regulatory
requirements, which, as a supervisor, I find reassuring!
And if we now look at how Tier 1 capital ratios have developed recently, we
can see another welcome development.
They are stable.
In the first instance, that is somewhat surprising, given that the balance
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sheet total of small and medium-sized banks has increased slightly, while
capital has marginally declined.
In fact, Tier 1 capital ratios could reasonably have been expected to fall too.
The fact that they remained stable can be explained by the reduction in the
riskiness of banks' balance sheets - because this is the basis for calculating
Tier 1 capital ratios.
That is also something I like to see as a supervisor.
As far as the liquidity of small and medium-sized institutions in Germany is
concerned, there isn't really a lot I can say.
Instead of there being too little liquidity, there is too much liquidity in
Germany.
And this liquidity is searching for yield.
First and foremost, high capital and liquidity ratios are sound preconditions
for the stability of small and medium-sized institutions.
They are good preconditions for the banking system being able to withstand
unfavourable market conditions or unexpected shocks - even over a
prolonged period.
It is important that these preconditions are met, because small and
medium-sized institutions are facing a series of risks and challenges.
The greatest of these challenges is the banks' business models and earnings
performance.
It's nothing new that some banks in the euro area are suffering from weak
profitability.
And that's not just since the period of low interest rates began.
It was also the case before that - including for some small and
medium-sized institutions.
In some countries, competition among banks for customers is rife - and it is
an unhealthy form of competition if risks and collateral are not priced in
correctly.
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In 2014 banks' return on equity was just over 3%, considerably lower than
what market participants would deem sustainable.
However, it is not just a question, for example, of whether there is sufficient
business among small and medium-sized enterprises and retail customers
for the roughly 1,650 banking groups in Germany.
It goes without saying that the prolonged period of very low interest rates is
not helping to remedy this weak profitability - on the contrary.
The vast majority of small and medium-sized institutions operate a
traditional business model that is heavily reliant on interest rates - and
consequently they are often harder hit than larger banks.
At the same time, those institutions that mainly extend credit to retail
customers are more severely affected by low interest rates.
It should come as no surprise that banks that primarily issue fixed-rate
loans have thus far coped with the low interest rates comparatively well.
However, I don't need to tell you that, as soon as loans and investments
with high and fixed interest rates expire and have to be replaced with
lower-yielding assets, these banks incur burdens.
Moreover, these banks will suffer from the effects of the low interest rates
for longer than banks that mainly grant variable-rate loans - the latter see
the benefits more quickly when interest rates go up again.
In order to safeguard earnings performance, small and medium-sized
institutions need to assess the efficiency of their business model - and
better sooner than later.
I will not give any detailed advice on business policy here - supervisors are
not the better bankers.
Fundamentally, though, banks have two options: they either raise their
earnings or lower their costs.
Let's look at the earnings side first.
It makes sense to create new sources of earnings that are less dependent on
interest rates - such as fees and commissions.
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A survey of German institutions conducted by the German Federal
Financial Supervisory Authority (BaFin) and the Bundesbank has indeed
revealed that more than half of the respondents have already expanded the
share of fees and commissions income in their earnings.
On the costs side, precisely German institutions have potential for savings.
By European standards, their cost efficiency is relatively low.
For every euro of earnings, they bear costs of almost 70 cent - compared
with just 50 cent in other countries.
However, the solution does not necessarily lie in merging small institutions
to ultimately create a large, systemically relevant institution.
On the contrary: "small is beautiful" is a good, if not better, alternative provided that "small" is sustainable in the long term.
In order to realise scale effects, banks could also centralise certain areas such as reporting, transaction settlement or some elements of risk
management.
The German savings banks and cooperative banks in particular already
have experience in this regard.
Whatever way the institutions choose, it's crucial that they keep proper
control of the risks they have taken on.
Banks are obviously not having an easy time right now.
They are obliged to increase earnings in times of low interest rates and
tough competition, but at the same time must not take any excessive risks
when doing so.
Many would liken this to trying to square the circle. I think it's more like a
system of mathematical equations with many unknowns - complicated, but
nevertheless resolvable.
There are always ways to revive your own business - even without incurring
excessive risks.
Digitalisation, for example, is opening new paths, which some alert
managers are already exploring - be it to develop new sources of income or
distribution channels, or to reduce costs.
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Cases in point are online banking through smartphones or advisory services
for customers by video conference.
Digitalisation also offers opportunities for small and medium-sized
institutions.
For these institutions, the trick will be to innovate, without losing sight of
their roots.
Ladies and gentlemen, business models and earnings performance are
currently the biggest challenges facing the banking sector - but they are not
the only ones.
For example, the activities of small and medium-sized institutions are often
very concentrated - on certain sectors or regions.
While that is in the nature of small and medium-sized institutions with a
regional focus, it also creates a dependency which makes them vulnerable.
So it is all the more important to take this concentration risk into
consideration in risk management - particularly with regard to its
qualitative elements.
If there is no way to avoid concentration risks, the principle of "know your
customer" gradually becomes more critical.
And that is exactly where the strength of small and medium-sized
institutions lies.
They know the risk profile of the individual borrowers as well as the value of
their collateral.
And they know the regional markets and their potential.
All this needs to be used by banks in the context of their risk management
and must continuously be taken into account in their decision-making in
order to ensure their success and survival.
It will come as no surprise to you that for me, as a representative of the
SSM, it is not just about business models, earnings performance and the
concentration of risks when it comes to small and medium-sized
institutions.
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As the SSM, we are always having to ask ourselves how we can support our
colleagues at the national supervisors.
Supervision - division of roles between the ECB and national
supervisors
Now let's move on to the division of roles that has been in place since
November 2014 for the supervision of small and medium-sized institutions
in the euro area.
As you know, within European banking supervision, the national
supervisors are responsible for supervising small and medium-sized
institutions - so in Germany, it's BaFin and the Bundesbank.
The ECB only plays an indirect role in respect of supervising small and
medium-sized banks - the point of contact is not the institutions
themselves, but rather the national supervisors.
Direct contact between the ECB and the institutions only occurs in
exceptional cases - for example with regard to the granting or withdrawal of
banking licences.
This indirect approach reflects two major principles underlying European
banking supervision: subsidiarity and proportionality.
Most small and medium-sized institutions have relatively low-risk business
models that are tailored to their region - direct European supervision is
generally not required here.
But what is the SSM's contribution, what is the contribution of European
banking supervision?
It is up to the SSM to give background support to the national supervisors.
Together with the national supervisors, we are developing high quality,
flexible standards and tools for risk-oriented supervision, which can take
into account regional aspects such as the size, business and risk profile of
the institution.
This indirect supervisory approach involves, for example, agreeing with the
national supervisors on the key components of a recovery plan for small
and medium-sized institutions.
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It also involves obtaining an overview of whether on-site inspections and
discussions are also taking place at these institutions; of whether the level
of supervision is tailored to the risk profile of the individual bank; and of
whether the national supervisors take macroeconomic developments into
account when conducting their risk analyses.
Let me make one thing clear, however: it is not our intention to remove all
particularities and replace national supervisory approaches with a
European approach.
Instead, we are trying to ensure that the key elements of supervision meet
certain minimum requirements.
This will enable national particularities to be taken into account - only,
however, if these particularities are justifiable in terms of risk. Something
we all agree on, I'm sure.
Taking this approach for the indirect supervision of small and
medium-sized institutions also ensures two things.
First, it ensures that the principle of the supervision being tailored to the
risk profile and size of the institution is safeguarded.
Second, it ensures that the principle of proportionality is fully upheld, as it
is up to each individual supervisor to use the supervisory tools in a
risk-oriented and proportional manner.
Small and medium-sized institutions fall indirectly under European
banking supervision.
But they benefit directly from it nonetheless.
After all, the objective of indirect supervision is to contribute to the stability
of national financial markets and in so doing reflect the importance and
particularities of small and medium-sized institutions.
European banking supervision has a much wider overview than national
supervisors.
The ECB can look at all countries in the euro area and it shares its insights
with the national supervisors.
It may well be that a number of national supervisors have already decided
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to intensify their supervision of certain institutions owing to the increase in
information.
Conversely, the ECB gains important insights into small and medium-sized
enterprises from the national supervisors.
The past few months, in particular, have shown that considerable contagion
effects can arise within a banking system.
Against this background, it is very important that the ECB covers and
understands a banking system as a whole.
This is also of benefit to the supervision of large, directly supervised
institutions.
For those exact reasons, European banking supervision can better prevent
future crises and that also helps small and medium-sized institutions.
After all, financial crises always damage the real economy too - and the real
economy is crucial for small and medium-sized institutions.
For the reasons I have mentioned, European banking supervision will also
boost the trust that customers and investors have in the banking sector.
And that too is of benefit to small and medium-sized institutions.
After all, trust is the foundation of banking - whatever the size of the bank.
The future - open issues relating to the supervision of small and
medium-sized institutions
Ladies and gentlemen, European banking supervision is barely
one-and-a-half years' old.
In that time, we have also made some headway with regard to small and
medium-sized institutions.
In close collaboration with the national supervisors, we have established a
set of common standards and methods - and, in many cases, the national
supervisors have at their disposal a range of methods and standards that
they can choose from.
We have therefore come a lot closer to achieving our goal of creating a more
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stable banking system.
Nevertheless, there are still a number of open issues.
One of those is reporting requirements that provide a minimum amount of
data.
In general, reporting is a controversial topic right now - and not just
because of AnaCredit.
There are still a number of misunderstandings that could be cleared up in
this regard.
In the wake of the financial crisis, the information needs of banking
supervisors have increased significantly - that's for sure.
The crisis quite clearly highlighted that the German reporting system did
not even fulfil the necessary minimum.
For example, the reports that had to be submitted on a regular basis did not
contain any information on country risks - for example to what extent the
institutions depended on what was happening in Greece or the United
States.
Subsequent ad hoc requests then had to be made, which were expensive for the banks and for the supervisors.
Sound risk analysis and effective supervision are only possible if the
appropriate data are available.
The increasing need for data obviously also affects small and medium-sized
institutions.
Of course, it's important to weigh up the costs and benefits when collecting
data.
That is required under the principle of proportionality.
In order to analyse the risks of a small or medium-sized bank, supervisors
need and ask for less data; in order to analyse the risks of a large,
international bank, they need and ask for more.
Accordingly, the reporting requirements are tailored to, among other
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things, the size of the institutions.
For example, in anticipation of future reporting requirements, we asked the
national supervisors last year, for the first time ever, to provide us with
supervisory data on all small and medium-sized banks.
They were asked to submit 37 separate data points, including the balance
sheet total, the level of customer deposits or the trading book portfolio - so
nothing complex at all.
By contrast, the banks that are directly supervised by the ECB are asked to
give more than 8,000 data points - and these have to be submitted not
annually but quarterly.
Our requests for information of course comply with the guidelines of the
European Banking Authority.
For indirect supervision, however, it is not a question of more reports.
It is much more about using the experience collected within the SSM for the
supervision of small and medium-sized banks.
For example, we are currently working on a concept for the Supervisory
Review and Evaluation Process, or SREP.
The SREP is the most important tool of banking supervision.
The supervisors analyse each institution's business model and governance,
as well as its capital and liquidity risks.
On this basis, national supervisors determine how much capital each
individual institution is required to hold.
Last year, for the first time ever, the SREP for the large banks in the euro
area was conducted in accordance with a common methodology - an
important step towards genuine European banking supervision.
From 2018 it is likely that, for small and medium-sized institutions, the
national supervisors will use a simplified methodology that covers the key
aspects.
Another thing that also plays an important role for small and medium-sized
institutions is the system of institutional protection schemes.
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More than half of all euro area banks belong to an institutional protection
scheme - large banks along with small and medium-sized institutions.
In Germany, four out of five institutions belong to such a protection scheme
- measured by balance sheet size, that represents 40% of the German
banking system.
Institutional protection schemes are therefore highly relevant for the
stability of the banking system.
But they are also important to supervisors for another reason.
Under European law, more specifically the Capital Requirements
Regulation (CRR), banks may be granted certain privileges if they belong to
a protection scheme.
For example, institutions need not necessarily hold capital against
exposures to members of the same protection scheme.
The decision whether to grant such a privilege is taken by the competent
supervisor - for small and medium-sized institutions, the national
supervisors; for large banks, the ECB.
There is therefore much to be said for granting these privileges in
accordance with uniform criteria - both across countries and across
institutions.
I'd like to be clear about one thing, however: the aim is not to call into
question the protection schemes in general.
The objective is to harmonise the supervisory treatment of the systems.
We have therefore defined the relevant criteria and are currently
conducting a public consultation that will run until the middle of April.
Concluding remarks
Ladies and gentlemen,
I began my speech with the conclusion that the term "less significant"
institutions is not justified for the group of small and medium-sized banks.
In view of the importance and particularities of this banking sector, I
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believe indirect European banking supervision to be necessary and
appropriate.
I also believe that the division of roles that has been in place since
November 2014 is clear and unambiguous.
Small and medium-sized institutions basically fulfil the ideal function of the
financial system: they finance the real economy.
However, this traditional business model is being challenged - at the
moment also by sluggish economic growth, weak investment and the
prolonged period of low interest rates.
In some countries, many banks have also for a long time been plagued by
relentless competition for too few customers for a large number of banks.
The German institutions, in particular, indeed have considerable reserves,
their customers are generally solvent and liquid, and the ratio of
non-performing loans is accordingly low.
Therefore, as a supervisor, I'm not immediately concerned.
Nonetheless, even these institutions should not try to just hold their breath
until they surface from the low interest rate phase.
They could rapidly run out of air.
The small and medium-sized institutions will not be able to avoid assessing
(in detail) the efficiency of their business model - and better sooner than
later.
Small and medium-sized institutions are subject to national supervision.
Nonetheless, European supervision still plays an important part, but
indirectly through cooperation with the national authorities.
These institutions benefit directly from European supervision, however;
trust in the banking sector is increasing, the information base for
supervision is becoming wider, the likelihood of crises is decreasing and
competition is becoming fairer.
After one-and-a-half years of European supervision, much has changed for
small and medium-sized institutions too.
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Reporting requirements are higher, the SREP is being harmonised and the
supervisory treatment of institutional protection schemes is being
standardised.
The ECB and the national supervisors are working together on
implementing these changes.
The objective is to exercise the best possible supervision, which follows the
principle of proportionality, takes appropriate account of national
particularities and reflects the particular importance of this banking sector
for the stability of national financial markets.
Thank you for your attention.
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Money markets after liftoff - assessment to date and
the road ahead
Simon M Potter, Executive Vice President of the Markets
Group of the Federal Reserve Bank of New York, at the 70th
Anniversary Celebration of the School of International and Public Affairs at
Columbia University, New York City
Thank you. It's an honor to speak to you today as part of the 70th
Anniversary Celebration of the School of International and Public Affairs at
Columbia University, and I would like to thank my former colleague and
longtime friend Trish Mosser for the invitation.
The programs offered by SIPA, which aim to train young leaders to address
the world's most pressing public policy problems, are especially relevant to
the mission of the New York Fed, and many members of the Bank's Markets
Group are alumni.
I'm here to offer a few thoughts on money markets and the implementation
of monetary policy.
Because of the large size of the Federal Reserve's balance sheet, the staff at
the Federal Reserve spent the past several years developing a new and
innovative framework to control money market rates, and working to
increase the amount of data we receive about trading in those markets.
In my remarks today, I will review the performance of this new framework
and discuss key insights from those new data collections.
Before 2008, bank reserves were scarce, and the Federal Reserve
influenced overnight interest rates by making small adjustments in the
supply of reserves.
The expansion in the Federal Reserve's balance sheet during and after the
financial crisis means that reserves are now abundant, and small
adjustments in the quantity of reserves will not have much influence on
overnight interest rates.
Instead, the Federal Reserve's new framework is premised on the payment
of interest on reserves and on ensuring sufficient competition in money
markets so that the rate of interest paid on reserves is passed through to
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other money market rates and thus to deposit rates offered to households
and firms.
Implementing policy in this new way has required a significant shift in the
staff's analytical focus, toward quantitative, data-driven analysis of money
market structure.
This work was accomplished by a large roster of highly talented staff at the
Board of Governors, the New York Fed, and elsewhere in the Federal
Reserve System.
Of course, the development of this new framework entailed frequent
interaction with the Board of Governors and the Federal Open Market
Committee (FOMC), which are responsible for the tools used to implement
monetary policy.
I'll focus my remarks on a few key questions.
First, what is this new framework and why was it necessary?
In this section, I will explain why the Federal Reserve was able to lift rates
off zero without requiring large-scale "reserve draining."
Next, what do the new data on money market trading say about how this
new framework is affecting market conditions?
As part of this discussion, I'll walk through the enhanced data that, starting
in March, the New York Fed will use to calculate the effective federal funds
rate.
Finally, what questions remain, and what can be done to learn more about
the issues they raise?
These include the level of capacity required in the Federal Reserve's reverse
repo operations and the consequences of changes in the regulatory rules for
banks and money funds.
As always, these views are mine alone and do not necessarily reflect those of
the New York Fed or the Federal Reserve System.
A new approach for policy implementation
Why are we following a new approach to implementing monetary policy?
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Before the financial crisis, the Federal Reserve followed a well-worn
playbook for monetary policy implementation that was based on scarcity of
reserves.
Reserves left at the Federal Reserve earned zero percent interest.
As a result, to achieve the FOMC's desired level of the federal funds rate, the
Open Market Desk at the New York Fed (Desk) estimated the amount of
reserves to add or subtract that would intersect supply and demand at the
target interest rate directed by the FOMC.
All else equal, if the Desk wanted interest rates to go up, it slightly reduced
the amount of reserves; if it wanted rates to go down, it slightly increased
the amount.
So long as the Desk was able to effectively forecast the appropriate amount
of reserves to add or subtract, temporary open market operations provided
it with an efficient means to add or subtract them, and therefore allowed for
good control over the federal funds rate.
These operations were conducted as repos or reverse repos secured by
Treasury securities or other high-quality collateral.
Back then, a typical day on the Desk focused on forecasting the demand for
reserves created by reserve requirements and other sources, and projecting
autonomous factors affecting reserves.
With very small amounts of excess reserves in the system, there was a
straightforward relationship between rates in a range of money markets.
Thus, the Desk was able to target a rate in one part of the unsecured market
by conducting small secured operations as needed with primary dealers.
Since the financial crisis, the environment has changed in two important
ways.
First, by the end of 2014, following the large-scale asset purchase programs,
the Federal Reserve balance sheet was funded by about $3.1 trillion in
liabilities other than Federal Reserve notes, which were mostly in the form
of reserves in excess of the amount banks were required to hold; in contrast,
there were only $64 billion of non-Federal Reserve note liabilities in June
2007, of which only about $2 billion were excess reserves.
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As a result, reserves are now anything but scarce.
Second, Congress granted the Federal Reserve an important new tool: the
authority to pay interest on reserve balances, or IOR.
In many countries, and in theory, a standing facility that pays IOR provides
a floor on interest rates.
The reason is simple: if a private counterparty can invest cash at the central
bank, then given the safety and convenience of this investment, it will
dominate any other overnight investment at that interest rate.
Further, if banks can acquire funds in the wholesale market at rates below
IOR, then competition for these funds will bid up these rates close to that
paid on reserves.
The Federal Reserve instituted interest on reserves in late 2008, and the
interest rate on reserves turned out not to be a floor; market interest rates
fell significantly below it.
With the large levels of excess reserves in the system, certain institutional
aspects of money markets in the United States - including bank-only access
to IOR, credit limits imposed by lenders and other impediments to market
competition, and the costs of balance sheet expansion - appear to create
frictions that have made IOR act more like a magnet that pulls up
short-term interest rates than a firm floor beneath them.
Thus, in considering how to implement policy normalization, the Federal
Reserve evaluated a variety of ways to increase competition for funds
among borrowers and thereby improve the control provided by IOR.
The Federal Reserve initially considered an approach to policy
normalization that was based on a combination of term operations and
asset sales or redemptions aimed at making reserves sufficiently scarce so
that, once the FOMC decided to tighten monetary policy, this tightening
could be implemented using IOR within a framework that was otherwise
similar to that used before the crisis.
As part of this approach, the Federal Reserve acquired a new set of reverse
repo counterparties, including money market funds and government sponsored enterprises, in addition to the primary dealers with which it had
traditionally transacted.
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These new counterparties were major investors of cash in overnight
markets and had capacity to facilitate the "draining" of substantial reserve
balances, if offered attractive term investments with the Federal Reserve.
In addition, the Federal Reserve developed a term deposit facility to drain
banks' reserve balances.
This playbook of draining reserves back to reserve scarcity to support the
transmission of interest on reserves into market rates is standard among
central banks.
If policymakers had chosen to do so, the Federal Reserve could have made
such a term reserve draining approach work to help control money market
rates in the United States.
So, why did the Federal Reserve not follow this approach of large-scale
reserve draining?
As the balance sheet continued to grow as a result of asset purchase
programs, it became apparent that such reserve draining operations would
have been very large in comparison to the size of private money markets.
As a result, they probably would have had lasting effects on the structure of
those markets - for example, by reshaping the structure of term money
market activity according to the structure of the Federal Reserve's
operations.
These lasting effects could have been especially large if the balance sheet
did not run off quickly.
For this reason, the Federal Reserve instead pursued offering an overnight
investment opportunity that could, with sufficient capacity, intensify
competition in money markets and, without necessarily draining reserves,
enhance the transmission of IOR into other overnight money market rates.
This approach entailed a twist on a traditional Federal Reserve tool, reverse
repos: Instead of running quantity-based, term operations aimed at altering
reserve levels, the Desk would run interest-rate-based overnight operations
aimed directly at influencing market rates.
A number of operational features were required to implement such an
overnight reverse repo, or ON RRP, facility: It would need same-day
settlement; the operation would need to be run predictably, every day, and
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as late in the day as possible, to give lenders time to bargain with other
counterparties using the outside option of investing with the Federal
Reserve; an appropriate spread below IOR would be required to ensure that
the facility neither induced large changes in the structure of money markets
nor lost the ability to support interest rate control; and the operations
would need enough unused capacity that lenders could credibly propose to
leave borrowers that did not offer an adequate interest rate.
This approach works in theory, and, with the support of staff across the
Federal Reserve System, a theoretical framework was developed around
money market rate control through the use of this framework.
The ON RRP facility was also tested for more than two years.
This theoretical and empirical examination gave the Federal Reserve
confidence that it could effectively raise rates when the time came while
limiting undesirable effects on financial market structure, and also ensured
that additional term tool options were available if the combination of the
overnight tools - IOR and ON RRP - was not sufficient to provide interest
rate control.
At this point, you might have a question: from late 2008 to late 2015, the
federal funds rate traded well within the FOMC's target range of zero to 25
basis points.
Shouldn't this have been conclusive evidence as to the ability of the
operational framework to provide sufficient control of interest rates?
Unfortunately, the answer is no, because there are natural features of the
financial system that likely provide support to interest rates near the zero
lower bound, or ZLB.
These features include the availability of physical cash and a behavioral
aversion by some money market investors to investing at negative rates,
and also encompass certain unique features of money markets in the
United States, such as legal and regulatory incentives applicable to money
market mutual funds and the ability of the government-sponsored
enterprises to leave unremunerated deposits at the Federal Reserve.
As a result, while the pre-liftoff testing suggested that the tools were likely
to work well, it wasn't possible to determine with complete certainty the
extent to which market rates were driven by the tools or by ZLB effects.
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So we couldn't completely rule out that the federal funds rate and other
money market rates might not go up one for one with rises in administered
rates.
One might also worry that money market rates might not move together as
rates rise, meaning that, for example, a disconnect might emerge between
secured and unsecured rates, or between overnight and term instruments.
Either situation could result in impaired transmission of monetary policy
into broad financial conditions.
Assessing the performance of the new framework
To summarize my conclusion about the performance of the operating
framework to date: I am extremely pleased with what we've seen so far.
In discussing why I view the framework as effective, it's helpful to start by
explaining what it means for the tools to work well.
I think about this issue through three lenses: interest rate control, avoiding
unintended impact on the structure of the financial system, and avoiding
financial instability.
I'll touch on what each of these mean, and then I'll review the quantitative
evidence since liftoff on how well things have gone.
Interest rate control
Clearly, interest rate control is the paramount objective.
It is of great importance that the public is confident that the federal funds
rate will be, on average over time, within the target range set forth by the
FOMC, and that other money market rates will continue to move closely
with changes in the federal funds rate.
This way, expectations for the FOMC's future policy stance will be properly
incorporated into the term structure of interest rates, and thereby
appropriately affect broad financial conditions and the broader economy.
It's not necessary that the effective rate stay within the target range each
and every day.
Before the crisis, there was usually a bit of variability in the effective rate
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owing to limitations on the Desk's ability to achieve completely precise daily
forecasts for reserve demand.
Now, as I said earlier, the FOMC sets the target as a range, not as a point
value.
The federal funds rate can vary within that range, and it could even move
outside that range on occasion, without materially affecting the economy.
We have instituted a data-driven, cross-market framework for evaluating
interest rate control.
In unsecured markets, we gather daily, transaction-level data through a
new Federal Reserve statistical collection called the FR 2420.
These rich data give us much greater insight than we had before the crisis
about how these markets are structured, which is important to developing
and maintaining an operating regime based on improving competition
among borrowers in money markets, in the context of a large amount of
reserves and substantial ongoing regulatory and business model changes.
Monetary control does not stop at the effective federal funds rate: The
Federal Reserve also wants to ensure that the stance of monetary policy is
passed through into other money market rates.
For example, we evaluate such transmission in the Treasury tri-party repo
market, the market in which ON RRP is conducted, by collecting similar
trade-by-trade data from clearing banks.
In addition to these overnight markets, we pay close attention to the
Eurodollar market, which I'll address later, as well as term money market
rates.
Avoiding unintended effects on the structure of the financial
system
A second lens for evaluating the operational framework is the extent to
which it avoids creating incentives that might result in undesirable changes
in the structure of the financial system.
This means that the framework shouldn't have lasting unintended effects
on how people invest their money or on how financial institutions interact
with each other.
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The Federal Reserve is operating the ON RRP on a temporary basis,
primarily because the balance sheet is currently large.
The FOMC's policy normalization principles and plans make the temporary
nature of the ON RRP clear by stating that it will be discontinued when it is
no longer needed to help control the federal funds rate.
This intention was noted again in the minutes to the January FOMC
meeting.
As a result, we expect that firms would not make structural changes in how
they operate in response to the ON RRP, to avoid the cost of unwinding
those changes when it is discontinued.
The intention of the FOMC to impose an aggregate cap on the ON RRP, as
described in the January minutes, will mitigate this risk.
We closely monitor industry structure and fund flows to detect whether the
framework is having any unintended impact.
For example, we watch banking data and money fund holdings to see if
savings are shifting between the two, because if such a shift had to reverse
as we wound down the ON RRP, those flows could potentially create costs
to the firms concerned and also unnecessary problems for market
functioning.
We also keep track of prime money funds converting into government-only
money funds, because if they do so on the mistaken impression that the
Federal Reserve would provide a risk-free investment opportunity
indefinitely and on a very large scale, they might later have to unwind that
change when their error became apparent.
Avoiding financial instability
The third lens for evaluating the framework is the extent to which the
framework avoids augmenting risks of financial instability.
In particular, the framework shouldn't create a risk that, in times of stress,
money market lenders will rapidly disintermediate their usual
counterparties and come to the Federal Reserve instead, such as through
the ON RRP facility.
Of course, flight-to-quality effects existed in financial markets long before
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we put the new framework into place - what I'm referring to is a situation
where the framework facilitates those effects or makes them larger.
We address the risk of sudden surges in take-up in a couple of ways.
For example, we can employ vigilant market monitoring to detect any such
shifts and allow the FOMC to formulate a response.
We also use per-counterparty caps, and can use an aggregate cap.
Evidence to date on control
Now, let's discuss what the data tell us about how well the framework
performed.
The distribution of traded rates in the federal funds market, shown in
Figure 1, essentially made a parallel shift higher after liftoff.
These data are drawn from the new FR 2420 data collection I discussed
earlier, and they show an average over all days from liftoff to this past
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Wednesday, leaving out December 31.
Nearly all trading occurred within the new range - it's normal for there to be
a little bit above the range - suggesting that our framework was broadly
effective in moving traded rates upward.
Because traded rates moved upward in this way, we have so far achieved an
excellent level of control over the federal funds rate.
Since December 17, the day after the FOMC meeting, the effective federal
funds rate, calculated under its current methodology as a volume-weighted
mean, has traded within the FOMC's new 25-to0-basis-point range on all
but one day, which I'll come back to.
This is shown in Figure 2.
The rate has averaged around 36 basis points, about 25 basis points above
its average level over the analogous year-ago period, when the target range
was zero to 25 basis points.
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Let's consider the calculation of the effective rate for a moment.
Last year, we announced some changes to that calculation, the most
significant of which is that, starting in March, we will switch to calculating it
as a volume-weighted median using data drawn from the FR 2420 data
collection, rather than a volume-weighed mean using data provided by
federal funds brokers.
The change in the data source was made to make the calculation process
more robust.
We changed the calculation methodology because, while the mean and
median are usually very close to one another, when they differ the median is
a better reflection of money market activity, and because using a median
enhances the reliability and integrity of the rate.
The New York Fed published a technical note this past July that describes
in detail the benefits of this change.
Our recent experience has confirmed the expectation that the transition to
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the median in March will result in little overall impact on the level of the
effective rate over time.
Figure 3 shows a time series of the mean and median rates computed from
the FR 2420 data.
As you can see, they remain quite close to one another.
The FR 2420 data also allow us to examine closely the distribution of traded
rates in the overnight Eurodollar deposit market.
For those who are not native speakers of money market jargon, the federal
funds and Eurodollar deposit markets are very similar: They are wholesale
funds taken in by banks, with definitional differences that I'll leave to the
footnotes to my speech.
Just this past October, following amendments to the FR 2420 collection, we
began to receive trade-level data for the bulk of activity in the Eurodollar
market.
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The Eurodollar market is considerably larger than the federal funds market.
According to FR 2420 data, on average in the last two months of 2015 there
was $233 billion of overnight borrowing in the Eurodollar market; in
contrast, over that same period, there was $70 billion overnight borrowing
in the federal funds market.
I'll show some data on the composition of activity in these markets a bit
later, but it's worthwhile noting that many of the Desk's nonbank
counterparties, such as the money funds, are active lenders in the
Eurodollar market.
We observed a similar response in yields in the Eurodollar market as we did
in the federal funds market, with the distribution of traded rates making a
parallel shift upward of about 25 basis points, as shown in Figure 4.
Since liftoff, the overnight Eurodollar volume-weighted mean rate as
calculated from FR 2420 data, as seen in Figure 5, has averaged about 35
basis points.
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This is in line with the effective federal funds rate.
The volume-weighted median, also shown in the figure, moved upward by a
like amount.
This is an encouraging development because it indicates that, as we have
moved up from the zero lower bound, money market rates are continuing to
move together.
We can look into that further by examining the overnight Treasury repo
market.
Rates on these transactions as reported by the tri-party clearing banks,
shown in Figure 6, exhibited a similar shift upward, although they settled
modestly lower in the target range than they had in the pre-liftoff period.
In part, this shift likely reflects the fact that the ON RRP offered rate was 5
basis points before liftoff - that is, 5 basis points above the bottom of the
target range - and it is now set to 25 basis points, or the bottom of the target
range.
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It also looks as though the increase in the federal funds rate passed through
effectively into term money market instruments.
Figure 7 shows the recent progression of rates on three-month Treasury
bills and three-month commercial paper.
Also shown for comparison is a three-month overnight index swap quote
for the effective federal funds rate.
All of these rates rose going into the December FOMC meeting, which
makes quite a bit of sense, given that most market participants expected the
FOMC to tighten policy at that meeting.
We also gather information about rates on term unsecured borrowing in
our FR 2420 collection, and about term secured transactions from the
clearing banks, and these data tell a similar story.
Treasury bill yields rose a bit less than other rates on instruments of
comparable term and now trade at yields somewhat below the ON RRP
rate.
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Treasury bills have some attractive qualities in comparison to ON RRP,
such as round-the-clock liquidity.
In addition, there seems to be strong demand for bills from investors who
don't have direct access to the ON RRP or IOR, and it appears that most
Treasury bills are owned by such investors.
Also, bills have typically traded below other money market rates during
tightening cycles, as they do now; periods where bills trade at or above
other rates have been the exception and not the rule.
Thus, the smaller increase in bill yields than in rates on other term
instruments is not surprising, and I do not read it as undermining the
general conclusion that the policy rate increase was effective in firming
money market conditions.
December 31
Now, I mentioned earlier that fed funds traded within the target range on
all but one day.
Let's talk about that day, which was December 31.
On that day, the effective federal funds rate, calculated as a mean from the
FR 2420 data, printed at 20 basis points, 15 basis points below its prior-day
value and 5 basis points below the FOMC's target range.
The median dropped a bit more, by 20 basis points to a level of 15 basis
points.
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In addition, as shown in Figures 8 and 9, the dispersion of traded overnight
rates in federal funds and Eurodollars increased on that day, with a
substantial amount of trading activity at fairly low rates.
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These year-end effects were transitory, and the level and distribution of
rates in the federal funds and Eurodollar markets returned to pre-year-end
conditions on the following day.
Although the effects were transitory and did not adversely affect policy
implementation, spending a bit more time on this episode can contribute to
our understanding of money market relationships.
Why did we see the year-end drop in unsecured rates?
Recall that the framework functions by creating opportunities for investors
to borrow funds in money markets to earn IOR whenever there are
significant differences between market rates and the IOR rate.
On quarter-ends, the actual and perceived marginal balance sheet costs of a
number of depository institutions increase as they publish financial
statements and calculate regulatory ratios.
These increased balance sheet costs mean that depository institutions
borrowing funds in money markets to earn IOR must do so at a lower
interest rate to account for these costs.
Further, the reduction in balance sheet capacity can temporarily lower the
bargaining power of lenders, again allowing borrowers to obtain funds at
lower rates.
Many lenders in the federal funds and Eurodollar markets with access to
the ON RRP facility responded to these low rates by increasing their use of
the facility, as shown in Figure 10.
However, other lenders remained in these markets, including those without
ON RRP access, those who received funds late in the afternoon after the ON
RRP operation had already occurred, and those for which the ON RRP was
not an acceptable substitute.
On this last point, for some institutions, the ON RRP is an imperfect
substitute to lending in private unsecured markets because, in the tri-party
repo system through which the ON RRP is settled, cash is not returned at
maturity until late the next day, whereas in private unsecured markets,
earlier return of funds can be negotiated.
These quarter-end effects, as measured by the effective federal funds rate,
are likely to appear a bit larger when we switch in early March to a median
calculation.
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As I mentioned, on December 31, the median fell a bit more than the mean
did, 20 basis points in the median versus 15 for the mean.
A larger relative decline isn't unusual; averaging across the quarter-end
dates in March, June, and September 2015, the median declined by 7 basis
points while the mean declined by 6.
The median declines more because it is, in most cases, a better measure of
the center of the distribution of traded rates - an issue the Desk analyzed at
some length in the technical note I mentioned earlier.
This difference between the two might grow a bit more as rates move
further from zero.
In secured markets, rates in the tri-party repo market on year-end were
relatively stable.
This makes sense, as ON RRP is a good substitute for tri-party repo with
private counterparties, and therefore this facility forms a fairly firm floor on
overnight repo rates for lenders that have access to the facility.
As I'll show in a moment, volumes declined in the private repo market, as is
typical on quarter-ends.
Evidence to date on other "lenses"
Turning to the second lens I noted earlier, we have achieved excellent
control while avoiding any unintended change in the structure of the
financial system.
Figure 11 shows RRP take-up over time, grouped by counterparty type.
Take-up, both in aggregate and at the counterparty-type level, has been
stable since liftoff.
Among the money funds shown in this figure, government-only funds make
up more of the demand on typical days, with funds that can invest in a
broader universe of money market instruments, called prime funds,
accounting for the balance.
This has also been stable since liftoff. Indeed, more recently, usage has
come down as unsecured and secured rates have firmed some.
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Even with zero usage, the ON RRP facility could still be effective in
underpinning the level for money market rates by supporting lenders'
bargaining power.
In addition, as shown in Figure 12, lending volumes in secured and
unsecured money markets have been stable, suggesting that the Federal
Reserve's facilities have not displaced activity in the private sector.
Figure 13 shows activity in unsecured markets by select lender types.
This shows that, post-liftoff, the composition of activity in these markets
also appears to have been stable.
Finally, I'd like to speak briefly to the third lens, avoiding financial
instability.
As you know, there has been quite a bit of volatility and risk aversion in
financial markets lately, and there has been no corresponding surge in ON
RRP demand.
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This continues to be an issue that the FOMC is thinking closely about, as
reflected in the January FOMC minutes.
Lessons learned on operational structure
We have learned a lot about the structure of our operations from our
experience with liftoff.
I will discuss a few of my observations.
Let's begin with quantifying the aggregate capacity limit.
At the December meeting, the FOMC directed that the ON RRP's capacity
be "limited only by the value of Treasury securities held outright in the
System Open Market Account that are available for such operations."
As a result, in practice, the ON RRP is currently being run with an aggregate
capacity limit of around $2 trillion, which is far in excess of typical daily
demand and well above the $300 billion capacity limit the facility had had
since September 2014.
As the FOMC made clear in the minutes to its March 2015 meeting, this
elevated capacity was intended to ensure a smooth liftoff, but the absence of
an aggregate cap is only temporary.
This is why the recent January minutes included a discussion of when and
how it will be appropriate to reinstate an aggregate cap.
So, what have we learned about the appropriate level of the cap?
It seems likely that having a very elevated aggregate capacity was helpful in
controlling market rates initially, perhaps because it showed the FOMC's
commitment to achieving interest rate control, but it's unclear exactly how
much available capacity, or "headroom," is needed to maintain such
control.
By way of background, determining the appropriate level of capacity
involves striking a balance between the "lenses" I discussed earlier.
Imposing a limit on the facility's capacity reduces the extent to which there
can be a disruptive surge of funds into the facility and the extent to which
private-sector investors can change their lending patterns by using the
facility.
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Thus, such a limit helps avoid financial instability and unintended effects
on the structure of the financial system.
However, a limit that is perceived as likely to bind weakens our control of
interest rates, because when demand exceeds capacity, the interest rate
paid on the ON RRP facility is determined by an auction and is likely to be
below the offering rate, thus reducing the efficacy of the facility in
supporting the federal funds rate.
Our recent experience suggests that having reasonably high aggregate
capacity can help improve control without necessarily encouraging greater
use of the facility.
When that capacity is great enough, money market lenders are confident
that they will be able to place funds with us at the administered rate, even
on financial statement reporting dates.
That confidence empowers them to demand rates from their borrowers that
are above the ON RRP offering rate.
Conversely, when the capacity is perceived as low, lenders worry that they
might not be able to place all their funds at reasonable rates.
This means that they might accept relatively low rates in money markets.
In addition, because of switching costs and other frictions as well as risk
aversion on the part of lenders, rates can decline days or weeks ahead of a
date on which the ON RRP is anticipated to reach its capacity, to levels so
soft that lenders reallocate funds to the ON RRP.
So, having a high capacity could actually reduce ON RRP take-up.
But as I mentioned earlier, it isn't clear exactly how high the capacity needs
to be to achieve the confidence of which I speak, and the benefits of high
capacity must be carefully balanced against the benefits of a tighter
aggregate cap in terms of avoiding financial instability and unintended
effects on the structure of the financial system.
Looking at the recent data, it's hard to precisely identify the extent to which
the very high capacity, relative to the previous limit of $300 billion, helped
to facilitate control beyond instilling confidence, as I discussed earlier.
One tentative indication that high capacity may be playing an important
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role is that unsecured rates appear to have settled in about the same
position relative to IOR as before liftoff, even though one might have
expected the widening in the IOR-ON RRP spread and the lower support
from the ZLB to result in some downward shift.
The ON RRP also has a per-counterparty cap, which was, and is, $30
billion.
It seems that the current level of the per-counterparty cap was also
adequately large for perceived individual "headroom," thereby supporting
lender bargaining power.
Figure 14 shows summary data on how frequently we receive large bids in
our operations at the ON RRP and term RRP facilities.
As you can see, we rarely see bids of more than $10 billion, and combined
individual counterparty usage across overnight and term operations has
never exceeded $30 billion.
Recently, we learned a bit about the term RRP operations.
We have been conducting these over quarter-ends as a way of providing
additional RRP capacity.
Additional capacity is available because term RRP operations are subject to
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a separate overall size limit, and because there is no per-counterparty cap in
those operations.
Counterparties appear to regard these as close substitutes for ON RRPs,
and as shown in Figure 15, we've typically seen that overall RRP take-up,
across overnight and term RRP, has been fairly stable across quarter-ends.
At this past year-end, there was essentially no take-up at the term RRP
operations.
The reason is that the aggregate and per-counterparty caps were sufficiently
high that market participants were confident that they would not bind, and
also because we conducted the term operations without any interest rate
premium relative to the overnight operations.
At prior quarter-ends, term RRPs were typically offered with maximum bid
rates a few basis points above the ON RRP rate.
The year-end experience suggests that market participants generally prefer
overnight RRPs to term RRPs if they offer the same rate, and that, if
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desired, adequate control over money market rates can be attained without
term RRPs, as long as there is adequate ON RRP capacity.
Finally, I'll offer a few observations on a daily repo operation I haven't yet
mentioned.
As a long-standing service to foreign central banks, foreign governments,
and international official institutions, the New York Fed runs an overnight
investment facility known as the foreign repo pool.
In this operation, at the end of each business day, account holders' cash
balances are invested in an overnight reverse repo secured by the Federal
Reserve's securities holdings.
The foreign pool is an autonomous factor affecting reserves and, as a result,
in the pre-crisis operating framework, the Desk would have to essentially
sterilize variations in the pool's size with repo operations.
Accordingly, the interest rate on the pool was slightly below overnight
Treasury repo rates in the market.
To ease the Desk's job in the daily forecasting of autonomous factors, tight
limits were imposed on customers' ability to rapidly vary the size of their
investment in the pool.
Since the crisis, the New York Fed has continued to provide the pool as a
service.
Investments in the pool continue to be paid the market-based rate I
mentioned.
Figure 16 contains some statistics on this rate relative to a measure of the
broad market rate.
We do not use the foreign pool as a means for implementing monetary
policy, and the change in the composition of Federal Reserve liabilities it
can generate has little to no impact in unsecured markets because of the
large amount of reserves in the system.
Recall that the current operating framework is not based on reserves
scarcity.
Use of the foreign pool has grown over the last year and a half, from a bit
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under $100 billion in mid-2014 to about $247 billion on February 17.
This growth isn't associated with liftoff, and it isn't because we have
changed the way in which the interest rate is calculated.
Instead, use of the pool has increased because over time the constraints
imposed on customers' ability to vary the size of their investments have
been removed, the supply of balance sheet offered by the private sector to
foreign central banks appears to have declined, and some central banks
desire to maintain robust dollar liquidity buffers.
Open questions
Compared with the relative calm of the pre-crisis period, money markets
have recently gone through a sustained period of substantial change.
Some of these changes are the result of regulations to improve the safety
and soundness of the financial system, others relate to business model
enhancements, and, of course, some relate to Federal Reserve activity.
The Federal Reserve continues to collect data on the structure of money
markets to determine whether any changes are needed in its operating
framework to ensure that its objectives continue to be met.
We are continuing to watch developments as business models adapt to the
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numerous changes in bank regulation introduced over the past few years.
We are interested in the extent to which these business model changes
impact the structure of money markets and thereby affect the form of
monetary policy implementation.
For example, we are monitoring developments in bank behavior that could
have implications for the transmission of monetary policy into market
rates.
Thus, we are paying close attention to the behavior of foreign banks on
financial statement reporting dates.
We are also keeping a close eye on how domestic banks continue to respond
to enhanced requirements on nonoperating deposits, which, for some
institutions, are fairly large relative to the size of their reserve holdings.
Should these business model changes increase the spread banks demand to
borrow funds in money markets to earn IOR, or should business model
decisions apparently related to regulatory changes alter broader dynamics
in money markets, this could result in upward pressure on ON RRP take-up
over time.
We are also paying close attention to developments in the money market
mutual fund industry and their potential impact on policy implementation.
The Securities and Exchange Commission recently announced new
regulations for these funds aimed at enhancing financial stability.
One important feature of these new rules is that government-only money
funds receive different regulatory treatment than prime funds, possibly
making government-only funds more attractive for some institutional
investors.
If the assets under management in government-only money funds were to
grow significantly, that could put upward pressure on ON RRP take-up,
since most fund managers consider the facility to be a government
investment.
As I noted earlier, we would not want to see growth in government-only
money funds if it were predicated on a mistaken impression that ON RRP
would be around indefinitely and with high capacity.
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Also, if assets under management in prime funds were to decline sharply,
this could possibly lead to less efficient transmission of monetary policy.
Finally, we want to keep an eye on relative value relationships in money
markets.
For example, the difference between customer-to-dealer and interdealer
repo rates has been quite volatile in recent months, apparently because of
growth in dealer balance sheet costs.
The road ahead
To summarize, in the period since liftoff, we have achieved excellent control
over the effective federal funds rate, and we have done so while avoiding
unintended effects on the financial system or financial stability.
The policy rate increase has passed through to other money market rates,
suggesting that the increase is affecting broader financial conditions as
expected and intended.
We still have a lot of work to do, both to observe ongoing structural changes
in financial markets and to formulate and implement any necessary
response in the Federal Reserve's monetary policy operations.
I believe we have thoughtfully considered these uncertainties, and I am
confident that we have appropriate policy tools available to respond as
necessary to them.
Thank you. I would be happy to take a few questions.
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The UK economy post crisis - a series of
unfortunate events?
Sir Jon Cunliffe, Deputy Governor for Financial
Stability of the Bank of England, at the Centre for
International Business Studies, London South
Bank University, London
There is a well-known myth - much loved in management schools - that if
you put a frog in boiling water it will jump out; but if you put it in cold
water and bring the water very slowly to the boil, its nervous system will
not register the temperature change and it will be boiled.
I am assured by zoologist friends that it is indeed a myth. Frogs sense
gradually changing temperatures like the rest of us. But it is an instructive
parable. Sometimes when you focus on incremental changes you can forget
the big picture until the water has become very hot - or very cold.
The Monetary Policy Committee (MPC) meets every month. We assess a
very wide range of changing data - for the world and the economy is
constantly changing.
The past usually becomes clearer but the future is always uncertain.
So as a policymaker occasionally it is worth standing a long way back and
asking "What did I expect to happen last year and the year before?
And what can I learn from what actually happened?". And, crucially, "Have
I been lulled by the ever turning kaleidoscope of data and missed a change
in the big picture?".
So tonight I want to stand back and review how I saw the big picture two
years ago and how what has happened since has changed my view. And
what evidence I am looking for to confirm my view of the likely future.
Slow healing story
Since the Great Recession of 2008/9 we have had the slowest recovery in
our modern history - slower than the recovery from the Great Depression.
For those of you familiar with children's literature, one title for the story of
the last eight years is "a series of unfortunate events".
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In this big picture story, the UK economy was hit by a very unfortunate
event, a massive financial crisis, leading to the deepest recession for 80
years.
Three years later, as it is just beginning to recover, the economy is hit again
by the effects - via confidence and financial market and trade - of the
euro-area crisis.
Three years on the economy finally picks itself up with a burst of strong
growth.
Unemployment falls at the fastest rate for 40 years, confidence recovers
and business investment starts to grow strongly. But pay growth and hence
incomes respond much less, reflecting in part the fact that productivity
growth does not recover.
And, in the latest chapter, just as we see signs of income growth and
productivity growth coming back into life, a deflationary shock from a
collapse of oil prices, which should boost the economy, allied to a slump in
emerging markets, pulls us back and the economy begins to slow.
Markets worry that the next chapter will be another unfortunate event.
I would call this the "slow healing" story. Recoveries from financial busts
tend to be slow and painful.
Indeed, that is why it is worth doing all that you can - in advance and in
good times - to avoid financial crises. The academic literature suggests it
takes an average of eight years to recover.
If in the meantime you are hit by other bad surprises it can take longer. And
in this story most of the events are related.
As many commentators have observed, as well as country-specific factors,
many of the stresses now seen in emerging markets are knock-on effects, if
not from the financial crisis itself, then from the responses to it in the
post-crisis recession.
One can tell a version of this slow healing and unfortunate events story for
the world economy as well as for the UK.
You can see that reflected in the IMF's forecasts for world growth. In every
one of the last five years the world economy has underperformed the
forecast.
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Indeed it has pretty much become an annual event that the world economic
growth forecast is downgraded as stresses emerge somewhere in the world
economy or there are serial disappointments on pay and productivity.
This is not to denigrate the IMF's forecasters.
You see the same effect in the Bank's own forecasts and in private sector
forecasting. For example, the Bank's growth forecasts made in 2010 were
derailed by the euro-area crisis.
These outcomes are a combination of not understanding at the outset how
slow the healing process from the 2008 crisis would be and subsequent
unforeseeable and unfortunate events.
Secular stagnation story
There is another rather different story however, one more reminiscent of
our friend the mythical boiled or frozen frog.
In this other world, we are not on a slow healing path, subject to a series of
unfortunate events. Rather, there are deep secular and structural forces
pushing down on our economies.
These began to have an impact before the financial crisis. But their effect
was masked somewhat by stimulative effects of the financial sector bubble
as it inflated and was only exposed in the post-crisis world.
In this story there is recovery from the crisis, of course, but it is recovery to
economies with both considerably weaker growth potential and
considerably greater vulnerability to shocks.
We are in a "secular stagnation" world but have not fully woken up to it.
There are different hypotheses as to why we might be in such a world. One
is that we are stuck in an era of very low demand because there are more
savers than opportunities to invest.
This is due to fundamental factors such as demographic changes, inequality
and preferences for low-risk assets.
When the supply of savings exceeds demand for borrowing the price - i.e.
the natural real interest rate - goes down.
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If this natural real interest rate is pushed down below zero and held there
by this imbalance between supply of savings and demand for borrowing,
central banks can't push demand back up and economies remain stuck.
In this world, neither central banks nor the private sector can easily break
the cycle; the government has to step in to borrow massively to invest thus
correcting the imbalance of savers and borrowers and pushing the natural
interest rate back up.
Another, somewhat different take, is that we are stuck in an era not of low
demand but of low supply growth. In this view, productivity growth slowed
in the 1970s after the benefits of the Second Industrial Revolution had
finished working through.
And, despite the manifest technological developments, such as ICT,
technological change has not since had an equivalent impact on
productivity.
Or, as Peter Thiel said: "we wanted flying cars, instead we got 140
characters".
This is a world in which it is harder for policy to boost productivity and
growth.
In these secular stagnation views of the world, the water around us was
getting colder before the crisis and has become colder since. But we have
not noticed it.
And it is this, rather than the slowness of the healing process and the
aftershocks of the crisis, that explains the serial disappointments in
economic growth.
I have set this out as two very different stories about what is happening "slow healing" and "secular stagnation".
Of course, given enough unfortunate events and enough repeated
disappointment on the pace of recovery, they could look and feel the same
for a long time.
There is much that is common to them. In both stories for a period of time,
productivity is lower, interest rates stay low for long and pay and income
growth is weak.
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But these effects are longer-lived in a secular stagnation world. It is quite
possible that we are in some combination of both worlds.
But I think it is important, especially when thinking about policy, to
distinguish the different forces that drive these respective stories about the
world.
The UK picture
Which brings me to the UK. When I joined the MPC over two years ago, the
data seemed to point quite firmly towards the healing story.
The UK was experiencing a burst of growth, driven by the return of credit
and confidence and pent-up demand from the recession and slow recovery.
Many commentators were arguing that the Bank was in danger of getting
behind the curve; these arguments grew louder as unemployment fell at its
fastest rate for 40 years.
The Bank's forecasts two years ago suggested that growth would fall back a
touch, but only a touch, to around its pre-crisis average of 0.7% per quarter.
Our forecast for growth in 2014,15,16 was 3.4%, 2.7% and 2.9%
respectively.
The reality has confirmed part but only part of that story. Over the course of
2014 and 2015 growth drifted down, slowly but consistently and by more
than forecast.
The economy grew at around 2% annualised in the last quarter of 2015 around 0.7 percentage points lower than the February 2014 forecast;
growth in 2015 was 0.2 percentage points lower. The Bank's most recent
forecast is for growth to pick up slowly over the next few years to 2.5%.
That is less than the average growth rate of nearly 3% in the decade before
the crisis but around the average growth rate in the last 60 years. It will,
according to the OECD, be the fastest growth rate among G7 economies this
year.
Over the period, inflation has been pushed down to around zero by the
strength of sterling and by the very sharp fall in the oil price. I hesitate to
describe the oil price fall as an "unfortunate event". Much of the fall is the
result of an increase of supply, the product of the oil investment cycle that
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accompanied oil prices staying at over $100 per barrel for much of the last
ten years.
That will have boosted consumption and supported growth in
oil-consuming countries like the UK.
But the speed and size of the fall has made the shock to inflation very
abrupt and exposed weaknesses in oil-producing economies.
And more worryingly some of the fall over the last 18 months has been due
not to an increase in supply but rather to slowing demand in emerging
markets especially China. This will have had an adverse effect on world
growth.
There are continued signs of strength in the UK economy. Consumer
confidence is near record levels and business investment intentions are
strong.
Housing market transactions and investment are picking up.
Credit has picked up and is growing around the rate of GDP.
On pre-crisis metrics, there are signs of tightening in the labour market.
Unemployment is now at 5.1% - its lowest level since 2006. Job-to-job flows
have picked up sharply and are nearly at pre-crisis levels and the vacancy to
unemployment ratio - a measure of labour-market tightness - is at its
highest level since 2005.
But, some things have still not improved as we had hoped. Despite being
stronger in the middle of 2015, pay growth has now fallen back to the 2%
range - roughly its average since the crisis.
And forward-looking surveys do not suggest any significant recovery in pay
growth is around the corner.
Productivity growth similarly showed signs of picking up in the middle of
2015 but has dropped back to annual growth of around a quarter of a
percentage point at the end of 2015. Unit labour costs have picked up a bit
over the last year.
The picture is not completely consistent across different measures but most
measures are subdued or expected to fall in the near term.
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Meanwhile, risks from the rest of the world economy have shifted and
increased.
Boosted by monetary policy, the euro area has recovered over the past two
years, albeit to low rates of growth.
The stresses around Greece and its creditors have so far been managed.
But the risk to the UK from a more severe hard landing in emerging
markets has grown.
Emerging market economies now account for more than half of global GDP
and they accounted for more than 95% of world economic growth between
2008Q1 and 2011Q4.
They are now facing a set of inter-related challenges, including high and
growing levels of debt to GDP, slowing economic growth, falls in
commodity prices which has hit commodity exporters and a strong US
dollar.
The healing process
How should we read this picture? Is it still slow healing, just slower and hit
by more adverse events than we expected?
Or, like our friend the frog, has the gradual nature of the drift down in
prospects and the fact that the deflationary shock looks so clearly to have
been externally generated lulled us into missing some more fundamental
shift?
Is the water around us much colder than we thought?
I think there is still some mileage in the slow healing story to explain the
drift down in UK growth and the failure of pay and productivity to recover.
One cannot repair quickly the damage to the global economy from the worst
international financial crisis for 80 years.
Some, but not all, of the effects of the financial bust and deep recession
have passed.
But some have not. I want to look now at some of these effects and
headwinds that may be holding us back.
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First, there are signs that there may still be some scarring effects in the
labour market.
The amount of average weekly leave taken - a sign of worker confidence has recovered sharply over the last two years but remains someway off its
pre-crisis level.
And long-term unemployment and the proportion of part-time workers
who say they want full-time jobs remains elevated.
To the extent that workers do not yet feel confident in asking for a pay
increase, that might be one reason why wage growth has been relatively
unresponsive to the sharp fall in unemployment.
And we may still be seeing some cyclical effects from changes in the
composition of those in work; low skilled, low paid workers tend both to
lose their jobs early in a recession and regain employment late in the
recovery.
The increases in employment over the last year or so have added
proportionally more younger and lower skilled workers and hence pushed
average pay down.
Second, on top of some of these scarring effects, the deflationary shock
from lower energy prices does seem to be having some effect on pay.
The Bank's Agents have reported that low inflation is restraining pay
awards.
And the resulting increases in real disposable income may have made
workers less willing to press for higher pay.
Medium term inflation expectations appear to remain anchored and
consistent with the inflation target.
But the current very low rate of inflation may have made it less necessary
for employers to increase pay now especially given low productivity.
As the deflationary shocks pass, any dampening effect of inflation on pay
should fade, providing inflation expectations remain well anchored.
Migration may have had some role in restraining wage growth too, though
evidence suggests that it has had only a small negative impact on average
British wages.
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Third, the economy is facing fiscal headwinds as the Government repairs
the damage to the public sector balance sheet from the crisis and the deep
recession.
This drag on growth will continue for a number of years. In the decade prior
to the financial crisis, government spending on average contributed 0.6
percentage points per year to GDP growth - over 2016-2018, the MPC
expect it to contribute 0.1 percentage points on average.
Fourth, headwinds from weakness in the world economy are also likely to
endure. Net trade detracts from growth in every year of the MPC's forecast
for UK growth.
Overall, the healing story is for me, the story behind the MPC's latest
forecast to which I subscribe.
Growth picks up slowly over the next few years, driven by domestic
consumption and business and housing investment.
As the deflationary shocks from oil prices and the past strength of sterling
wane, the closing of the output gap and consequent domestic cost pressures
push inflation slowly back up to target.
This forecast is premised on a market yield curve in which interest rates rise
gradually though to levels substantially below their pre-crisis average.
The forecast recognises the risks to this picture from another unfortunate
event in the form of a harder landing in emerging markets.
Secular signals?
But while one can still explain the current conjuncture this way, there must
be less confidence in the healing story than when I first arrived on the MPC.
We have already incorporated a weaker structural picture into our thinking.
A few years ago we were expecting a period of above trend productivity
growth to recover some of the productivity growth lost during the Great
Recession.
We no longer expect any catch-up of the lost productivity growth and
indeed, productivity growth in our latest forecast only recovers to 1.8%,
compared to 2.7% between 1950-2007 and 2.2% in the decade before the
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crisis. This downgrading of prospects is true more broadly - according to
the IMF, potential output growth in advanced economies fell from 2.2%
over the period 2001-07 to 1.5% over 2013-14.
And the natural rate of interest probably remains around, or a touch below,
zero. This is the unobservable underlying real interest rate that is consistent
with inflation at target and economic activity at its potential.
One cannot observe this "natural rate" directly; it has to be estimated and
that is difficult to do with precision. In the crisis, estimates of this rate were
deeply into negative territory, which is why the MPC cut Bank Rate to 0.5%
and launched quantitative easing (QE).
The MPC's asset purchases can be thought of as equivalent to reducing the
level of Bank Rate, since both policies provide stimulus to activity and boost
inflation. If you adjust real Bank Rate to factor in the effects of QE, the
resulting, "adjusted", rate is probably below zero at present.
Our latest forecast is consistent with the natural rate and adjusted Bank
Rate recovering slowly. But it is very much part of our thinking that the
natural rate of interest will not rise to pre-crisis levels which is why we
believe increases in Bank rate will be both gradual and limited.
Moves in financial markets may also be signalling nervousness in the slow
healing story. Financial markets drifted down in the second half of 2015
and they fell quite sharply in the first months of this year.
Some of these moves have recovered a bit in the last week or so. But
nevertheless current market signals seem to be suggesting a structurally
weaker economic picture.
UK 10-year real yields are negative.
And yield curves are flat as far as the eye can see - the 5-year point on the
UK forward market interest rate curve has fallen by around 0.8 percentage
points to 1% in the last month.
It is difficult to identify any really major economic news in 2016 that might
underlie this.
Rather it may be that markets are shifting to a new perception of the world
economy and risks, and of policy-makers' ability to respond to future
challenges.
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Policy implications
What does all of this mean for policy? While the water has not become as
warm as two years ago I thought it would, I do not yet see enough evidence
that we have missed some shift to a permanently colder environment.
My central expectation remains that as the effects of the crisis continue to
heal and as the deflationary effects of past sterling strength and oil price
falls wane, domestic cost pressures will gradually push inflation back to
target.
I will be looking to see that consumer confidence remains robust and
business intentions remain strong.
I will be watching to see if pay growth picks up as disinflationary pressures
fade and if productivity growth accelerates as a result of the pick-up in
investment and of the tightness of the labour market.
And I will be looking very carefully at the risks of another unfortunate event
for the UK economy from a hard landing elsewhere in the world. If
economic growth falters and pay and productivity remain stuck at current
levels then the healing story will become increasingly less convincing.
There are of course other possible stories one can tell about the economy
and other risks. I want to mention three.
The first is the possibility, much in the news two years ago, that monetary
policy will not react in time to the build-up of inflationary pressure.
Monetary policy typically has its peak impact on inflation somewhere
between 18 and 24 months ahead.
The risk here is that when the current external disinflationary pressures
subside, domestic cost growth pressures will have built up and will push
inflation above target before monetary policy can restrain it.
I would not discount this risk. The labour market has clearly become much
tighter.
And if pay is being held down by cyclical or scarring effects, these could
change quickly. And there has been a substantial depreciation in sterling in
the past three months which will push up on inflation, possibly more
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quickly than the usual prolonged lag between changes in the exchange rate
and inflation.
But with interest rates near the effective lower bound, with powerful
disinflationary forces from abroad likely to persist for the next year, with
low growth in unit labour costs and with an economy growing at around
2%, I think this is the lesser risk.
Second, there is the concern that continued low interest rates lead to the
build-up of financial stability risks through an acceleration of credit growth,
increase in bank leverage and household indebtedness.
The financial system has only recently come back to life with economy-wide
credit now growing in the UK at around the rate of GDP.
While there are some elements of credit that are growing more strongly,
such as buy to let mortgages and unsecured debt, I think we are now
emerging from the post-crisis phase and in a more standard stage of the
credit cycle and we now have macroprudential tools to manage risks as they
build up.
Of course, even after paying down debt following the crisis, UK households'
indebtedness is high by historical and international measures so there may
not be a great deal of room for growth in this area if we want to avoid
vulnerabilities building up in the economy generally.
The growth in credit since the crisis, however, has been in emerging
markets rather than in advanced economies which brings me to the last risk
- an unfortunate event from some form of a hard landing in major emerging
markets.
These are now a large part of the world economy and debt stocks in many
emerging economies have grown sharply over the last eight years.
This could amplify the stresses many of these economies already face from
the inter-related effects of slower emerging market economy growth, much
lower commodity prices and a stronger dollar.
A more severe slowdown and debt-related financial stress in key emerging
markets could well have an impact on advanced economies, including the
UK, through a number of channels.
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One reassuring point is that the major UK banks and building societies
were tested against precisely this scenario by the Bank of England in 2015
and demonstrated they had the resilience to weather such a shock and carry
on lending to the UK economy.
Conclusion
Looking back over the last two years, I think that the slow healing story can
still explain where we are and provide a guide to our future prospects.
But the story has to be adapted in the face of more UK and world weakness
than I had expected and this weakness might be signalling that there are
deeper structural factors at work.
Nonetheless, my central projection remains that the UK economy will
continue to grow solidly and that inflation will return to target over the next
few years.
But, as always, policymakers need to be alive to the possible meaning of
disappointments, to be very sensitive to the possibility of changing
temperatures around them, and to the risk of unfortunate events.
We have a range of tools at our disposal and should be ready to use them
whichever risk materialises.
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UIC-SEC Joint Symposium to Raise Public Awareness:
Combating Pyramid Schemes and Affinity Frauds Opening
Remarks
Andrew Ceresney, Director, Division of Enforcement
Chicago, IL
Good morning everyone. Thank you, Dr. Poser, for the warm welcome. It’s
my privilege to be here taking part in today’s symposium on the very
important topic of affinity fraud and how we can protect our communities
from it. I’d like to thank UIC and Chancellor Amiridis for partnering with
the SEC and hosting this public outreach initiative. I’d also like to thank our
colleagues in law enforcement and the regulatory community, as well as the
members of the community, who have taken the time to attend today.
Before we get started, I must give our standard disclaimer that the views I
express today are my own and do not necessarily reflect the views of the
SEC or its staff.
Since many of you may not be particularly familiar with who we are and
what we do, a little background on the SEC is probably in order. At the SEC,
our tripartite mission is to protect investors, maintain fair, orderly, and
efficient markets, and facilitate capital formation.
The SEC is made up of different divisions, including the Enforcement
Division, which furthers the SEC’s mission by investigating and bringing
charges against violators of the federal securities laws.
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The idea of these actions is to both punish misconduct and to deter it, as
well as to compensate harmed investors. The Office of Investor Education
and Advocacy is responsible for educating investors on investments and
fraudulent schemes, as well as liaising with the public.
Violations that target retail investors are a prime focus of the Enforcement
Division’s investor protection efforts. We protect the interests of retail
investors by bringing bad actors to justice and by returning money to
victimized investors.
While scams targeting retail investors may not grab the same level of public
attention as violations by large companies and big banks, they are very
important, and we are committed to focusing on violators who prey on
retail investors.
In recent years, one area where we have seen a proliferation of attacks
against retail investors is pyramid schemes. These schemes often target
working class and immigrant communities, the most vulnerable retail
investors.
And combatting pyramid schemes is a priority at the SEC. Since 2012, we
have brought 11 actions involving pyramid schemes that we allege did – or
were set to – fraudulently raise over $4.2 billion from investors.
In my remarks today I will discuss some of these actions, the trends we are
seeing in this space, and how the work of our nationwide Pyramid Scheme
Task Force is helping to raise awareness of these types of frauds.
Pyramid Schemes and Multi-Level Marketing
First, a little about pyramid schemes. Pyramid schemes typically involve
what’s commonly referred to as a multi-level marketing program, or MLM.
A legitimate MLM program involves selling a genuine product or service to
people who are not in the program. Participants get compensated based on
the products or services that they, or the distributors that they recruited,
sell to others.
However, some MLM programs are actually pyramid schemes, in which
participants profit not from the product they are selling but almost
exclusively through recruiting other people to participate in the program.
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In these schemes, there is usually no genuine product or service. Instead,
participants in these schemes frequently claim to own, or be developing,
some sort of ethereal technology service, such as Chinese media cloud
computing services, Voice over Internet services, Internet marketing
through websites, or undefined e-commerce services.
These MLM schemes often target vulnerable and immigrant communities
and can be global in scale.
Over the past few years, we have noticed what seems to be an increase in
the number of complaints regarding such frauds. One common
characteristic we have observed in our cases in this area is the increasing
use of new technologies, most notably social media, to rapidly expand the
reach of these fraudulent schemes.
The use of social media, such as YouTube, Twitter, and Facebook, allows
fraudsters to publicize and replicate their schemes very quickly, as well as
reinvent them with new names. It also contributes to their international
scope, making it economically viable for fraudsters to target investors in
many countries at once.
Today’s scam artist can leverage social media and other technologies to turn
what, ten years ago, might have been a $5 million fraud involving a few
hundred investors, into a $100 million scam ensnaring tens of thousands of
investors worldwide. These frauds are easily duplicated, and at times, we
find ourselves playing “whack-a-mole,” chasing the same set of fraudsters
who, after feeling a bit of heat, simply close down one scheme and quickly
set up a new one under a different name.
The SEC has responded aggressively to MLM-based pyramid schemes by
filing emergency actions designed to shut down the frauds, freeze ill-gotten
assets, bring the perpetrators to justice, and ultimately return money to
harmed investors.
For example, in 2014, the SEC announced charges and an asset freeze
against the Massachusetts-based operators of a large pyramid scheme
called TelexFree that raised $3 billion from investors around the world.
TelexFree initially targeted Latino immigrants in the U.S. and then
expanded its targets to multiple affinity groups in the U.S. We alleged that
eight of TelexFree’s operators sold securities in the form of TelexFree
“memberships” that promised annual returns of 200 percent or more for
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those who promoted TelexFree by recruiting new members and placing
TelexFree advertisements on free Internet ad sites.
So far, we have succeeded in freezing tens of millions of dollars from this
alleged scheme, and the criminal authorities have seized significant
property holdings and high-end cars alleged to be proceeds of TelexFree.
On October 1, 2015, the first day of the new fiscal year, the SEC announced
fraud charges and asset freezes against Steve Chen, the operator of a
worldwide pyramid scheme, and 13 California-based entities, alleging that
they raised approximately $32 million from investors through false
promises of profit from a venture purportedly backed by the company’s
massive amber holdings.
Recently, in December 2015, in a case investigated by our Chicago regional
office, the SEC charged a company called TeamVinh.com and its Chairman
and CEO, Vinh Le, with fraudulently raising more than $3 million from
over 5,600 investors throughout the United States and in various foreign
countries.
In that case, we alleged that Le, who previously had been convicted of
forgery and barred from offering or selling securities by state authorities in
Minnesota and Wisconsin, and TeamVinh lured unsuspecting investors
into buying memberships in a program that Le and TeamVinh claimed to be
a referral network that investors could use to earn an income from MLM
companies without the investors having to do any work.
In fact, these memberships lacked any legitimacy; as alleged in the SEC’s
complaint, investors never received the promised payments, and Le
misappropriated the overwhelming majority of investor money to fund his
own lavish lifestyle, including spending more than $2 million of investor
funds at a Las Vegas casino.
Our actions in this space also demonstrate the different tactics we are
prepared to use when charging the promoters and architects of pyramid
schemes. In addition to including fraud charges, we routinely charge
certain defendants with other violations, such as violations of the
registration provisions of the Securities Act of 1933.
Our ability to charge registration violations – which are generally easier to
prove than fraud – enables us to bring violators to justice and obtain relief
for harmed investors in a more efficient and timely manner.
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We also can charge individuals who may have obtained ill-gotten gains, but
whom we cannot show were involved directly in the misconduct, as relief
defendants, thereby maximizing our recoveries to victimized investors.
Affinity Fraud
As I mentioned, affinity fraud that targets members of identifiable groups,
such as ethnic, immigrant, military or religious communities, is another
theme we see in connection with these schemes, as well as other types of
schemes.
Affinity frauds typically involve investments that turn out to be fake, or
contain lies about important details of the investment. The investment
opportunities often promise sky-high profits with little or no risk, which are
classic warning signs of fraud.
The fraudsters are commonly members, or pretend to be members, of the
group they are trying to defraud. In addition, the wrongdoers often try to
enlist respected leaders from the affinity group, who may not be aware of
the fraud, to convince others to join the investment.
Many affinity frauds are pyramid or Ponzi schemes, where promoters of the
scheme approach investors with what appears to be a legitimate investment
opportunity.
When new investors give their money to promoters, some of the new money
is paid to earlier investors so that it looks like the so-called investment is a
successful one. However, Ponzi and pyramid schemes have baked within
them a fatal flaw – in order for the scheme to continue, new participants
must continually be found to pay off existing investors. Therefore, all
pyramid and Ponzi schemes are ultimately doomed to collapse, invariably
leaving defrauded investors in their wake.
The SEC has brought significant actions involving affinity-based schemes
victimizing a wide spectrum of groups, including the military,
Asian-American and Latino communities.
For example, in August 2013, the SEC’s Chicago Regional Office brought an
emergency action to halt an approximately $1.8 million investment scheme
by former Marine Clayton Cohn and his hedge fund management firm
Market Action Advisors.
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We alleged that Cohn masqueraded as a successful trader to defraud fellow
veterans, current military, and other investors, and that he lied to investors
about his success as a trader, the performance of the hedge fund, his use of
investor proceeds, and his personal stake in the hedge fund.
Cohn allegedly only invested less than half of the money raised from
investors and instead used more than $400,000 for such personal expenses
as a Hollywood mansion, a luxury automobile, and extravagant tabs at
high-end nightclubs.
He allegedly used his lavish lifestyle to carefully contrive the image of a
successful trader and investor, when in reality he lost nearly all of the
money invested through the hedge fund. In order to cover up his fraud and
continue raising money from investors, Cohn allegedly generated phony
hedge fund account statements showing annual returns exceeding 200
percent.
Another example is the SEC’s 2014 charges and asset freezes against the
operators of a worldwide pyramid scheme targeting Asian and Latino
communities in the U.S. and abroad. We alleged that three entities
collectively operating under the business names WCM and WCM777 and
controlled by “Phil” Ming Xu posed as MLM companies in the business of
selling third-party cloud computing services.
We alleged that the defendants raised more than $65 million from tens of
thousands of investors who were promised a return on the cloud services
venture of 100 percent or more in 100 days. However, rather than building
out cloud services or incubating high-tech companies, we allege that Xu and
the WCM entities used investor funds to make Ponzi payments of purported
investment returns to some investors and purchase golf courses and other
U.S.-based properties.
Finally, about a year ago, we charged three company officers and 12
promoters behind an international pyramid scheme targeting Latino
communities in the U.S. In that case, we alleged that the three Portuguese
companies – operating under the name Wings Network – claimed to run an
MLM that offered digital and mobile solutions to customers, including apps
and cloud storage.
In fact, Wings Network’s revenues actually came solely from selling
memberships to investors, not from the sale of any products. The company
relied upon the recruitment of new members for funding, and commissions
were paid to earlier investors with money received from later investors. The
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scheme allegedly raised at least $23.5 million from thousands of investors,
including many in Brazilian and Dominican immigrant communities in
Massachusetts.
In addition, in a case that originates from our Chicago Regional Office, we
charged Neal Goyal, an investment manager, with fraudulently raising over
$11 million from members of the Indian-American community.
In this action, which will be a focus of one of today’s panels, we alleged that
Goyal told investors that the private funds he managed would invest in
securities following a “long-short” trading strategy.
However, Goyal actually did little trading and simply operated a Ponzi
scheme that used new investor funds to pay redemptions to existing
investors and fund his own lavish lifestyle.
Goyal concealed the poor results of the few investments he did make by
sending investors phony account statements that grossly overstated the
performance of the funds. We obtained an order freezing his assets and the
Commission subsequently barred him from the securities industry.
The SEC’s Pyramid Scheme Task Force
After seeing an increase in complaints regarding pyramid schemes and
affinity fraud, the SEC formed a nationwide Pyramid Scheme Task Force in
June 2014 to provide a disciplined approach to halting the momentum of
illegal pyramid scheme activities in the United States. The goal of the Task
Force is to target these schemes by aggressively enforcing existing securities
laws and increasing public awareness of this activity.
The Division is deploying resources to disrupt these schemes through a
coordinated effort of timely, aggressive enforcement actions along with
community outreach and investor education.
More than fifty SEC staff members are part of the nationwide Task Force,
which is enhancing its enforcement reach by collaborating with other
agencies and law enforcement authorities. We are also using new analytic
techniques to identify patterns and common threads, thereby permitting
earlier detection of potential fraudulent schemes.
Collaboration with other regulators, including criminal authorities, is an
important goal of the Task Force. To advance this goal, the Task Force has
hosted an interagency summit attended by over 200 representatives from
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other federal and state agencies and has presented at local trainings and
agency-specific conferences. And, of course, we have partnered with other
regulators and criminal authorities to bring high-impact actions in this
space. For example, one month after we filed our enforcement action
against the operators of the TelexFree pyramid scheme, two of TelexFree’s
principals were charged by the criminal authorities.
On the same day we announced our charges against Mr. Goyal, he was
charged criminally based on the same facts and circumstances that gave
rise to the Commission’s charges against him. Mr. Goyal subsequently pled
guilty, was sentenced to six years of imprisonment, and ordered to pay
more than $9.2 million in restitution.
Public outreach also is a significant goal of the Task Force. We message our
actions in this space through translating our public announcements and
charging documents into the native languages of the targeted investors. We
have a page on our website aimed at investor education about these
nefarious frauds.
The Task Force, in conjunction with the SEC’s Office of Investor Education
and Advocacy, has prepared investor bulletins warning of the dangers of
pyramid schemes and affinity fraud.
We also strive to educate communities about the red flags of pyramid
schemes and increase public awareness of pyramid schemes through
collaborative outreach efforts such as today’s event.
We have an exciting program this morning, beginning with a panel focused
on raising public awareness of affinity fraud, the red flags of Ponzi and
pyramid schemes, and the tactics used to induce targeted group members
to invest in such scams.
Our second panel will discuss resources that are available to protect
communities from affinity fraud. Both panels will also highlight
enforcement efforts to combat these types of fraud. I am sure these panels
will be thoughtful and effective in conveying the hallmarks of these schemes
and how we can collectively work to end them.
Conclusion
Thank you for your time and participation in today’s symposium. The SEC
is the cop on the beat in the securities markets and we want you to know
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that we are aggressively combatting the serious misconduct that pyramid
schemes and affinity frauds represent.
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Solvency II implementation - beyond
compliance
Gabriel Bernardino Chairman of the European
Insurance and Occupational Pensions Authority
(EIOPA) at the IVASS Conference 2016 “The
Launch of Solvency II”, Rome
Ladies and Gentlemen,
Introduction
Before I start I would like to thank the Italian Insurance Supervisor –
IVASS - and its president Salvatore Rossi for organising this conference and
for hosting it in this beautiful setting.
It is a great pleasure for me to be here today to contribute to the discussion
on one of the milestones in the history of EIOPA – the implementation of
Solvency II.
Summary
The title chosen for this conference is particularly relevant for EIOPA
because the word “launch” perfectly reflects our current frame of mind.
-
I will start by explaining why this is, and EIOPA’s role in the
implementation of Solvency II.
-
I will then focus on some important challenges related to the
implementation of the new risk-based regime, and what should be done
in order to deliver on the intended objectives of Solvency II.
-
Finally, I will share my views on the post-evaluation process that will
guide us to the Solvency II review.
Background
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The first regulatory journey of EIOPA was completed in 2015. So on 1
January 2016 a new, more challenging and much more important
supervisory journey began.
This is the convergent implementation of the new risk-based regulatory
framework across the European Union.
This is EIOPA’s mission, and I am confident that our unique position as a
European Authority, working together with the National Competent
Authorities (NCA’s), will allow us to provide a good level of consistency of
supervisory approaches and practices.
We have been preparing for this journey for the past two years.
From regulation to supervisory convergence
Why is supervisory convergence so important? Because it is essential in
order to achieve three fundamental objectives:
-
Firstly, to ensure that European Union regulation is applied in all
Member States;
-
Secondly, to guarantee a level playing field and prevent regulatory
arbitrage in the internal market;
-
Thirdly, to safeguard a similar level of protection to all policyholders
and beneficiaries in the European Union.
Given the current differences of supervisory cultures and practices between
Member States, I appreciate that our new journey might turn into an
“Odyssey”.
But it is the right “Odyssey” for us to be undertaking.
The European Union has to have a common supervisory culture and this is
precisely why EIOPA and the European System of Financial Supervision
(ESFS) were created.
We are decisive and fully committed to enter this new journey for the sake
of a more coordinated and more robust financial supervision in Europe.
In the coming five years one of our main priorities will be to increase
convergence towards a European supervisory culture.
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A risk-based culture that:
-
Aims to ensure strong but fair supervision;
-
Is based on a forward-looking approach to risks;
-
It takes into account that it is always better prevent than repair.
-
Prioritizes the dialogue with market participants in order to better
understand their business models, strategies and underlying risks;
-
Promotes early enough awareness and supervisory action in order to
protect policyholders and mitigate possible disruptions in the market.
EIOPA’s actions and tools
So how exactly is EIOPA building a common supervisory culture? Let me
mention a number of examples.
Firstly, EIOPA is building a comprehensive information system based on
the data collected under the new harmonized Solvency II reporting
templates.
With this system, the insurance supervision in the EU will have a new vital
asset:
-
It will further develop the capacity to provide reliable risk analysis and
early warning indicators, both at individual, group and system-wide
level;
-
It will improve the supervisory understanding of cross-border groups;
-
It will provide NCAs with peer group comparisons, increasing
supervisory capabilities at the national level.
In one word, it will reinforce the quality of both micro- and
macro-supervision in the European Union.
Secondly, EIOPA is developing on a step by step basis a Supervisory
Handbook setting out good risk-based supervisory practices on different
areas of Solvency II.
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In the Handbook we have already covered areas like: risk assessments; how
to supervise board responsibility within the Solvency II governance system;
business model analysis; supervision of technical provisions; prudent
person principle in investment policies and monitoring of internal models.
And we encourage NCAs to implement these good practices in their
supervisory processes.
Thirdly, a special attention is devoted to the on-going monitoring of
internal models, an area where material differences can have a huge impact
in the level playing field and policyholder protection.
EIOPA already issued in 2015 a couple of supervisory Opinions with
recommended practices to NCAs and this work will continue this year by
prioritizing the areas where different approaches lead to a material impact.
Going forward we will focus on the development and testing of sound
on-going appropriateness indicators and benchmarking for internal
models.
This work will be fundamental to ensure that internal models will continue
to fulfil the required standards and avoid that they become a capital
optimization tool.
A race to the bottom will kill the underlying idea of an internal model.
And we’ve done much more over the past two years:
-
EIOPA delivered the Solvency II Implementing Technical Standards
and Guidelines. Some Guidelines concern the basic alignment of
supervisory processes while others provide clarity to firms on what
supervisors’ expectations are. I am convinced that without Solvency II
Guidelines, undertakings would have faced hundreds of pages with
different national solutions and it would have been much more
complicated to achieve supervisory convergence.
-
Colleges of supervisors across the EU have been fundamental to
increase the exchange of information and to move towards a more
common analysis and measurement of risks.
As of January 2016, we are publishing on a monthly basis the risk free
interest rate term structures to be applied by all insurance and reinsurance
companies in the calculation of their technical provisions.
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The use of harmonised discount rates will ensure a more consistent
calculation of technical provisions by insurers and reinsurers throughout
the European Union.
Going forward, “Peer reviews” will continue to be used to compare and
assess the quality of implementation of Solvency II and corresponding
supervisory practices, followed by concrete recommendations to address
the issues identified.
Furthermore, EIOPA’s Oversight team will continue the bilateral
engagement with NCAs, providing independent and challenging feedback
on supervisory practices, facilitating cross-border discussions and
supporting improvements in local supervision.
In this context, the 2015 balance sheet review done in cooperation with the
local supervisor in Romania proved to be essential to increase the
credibility and enhance consumer protection and confidence in the
Romanian insurance sector.
A similar exercise is currently being organised in Bulgaria.
EIOPA’s oversight work is already starting to prove its vital importance in
ensuring strong but fair supervision and a forward-looking approach to
risks.
Challenges in Solvency II implementation
Let me now turn to three main challenges related to the Solvency II
implementation and the expectations from the supervisory side.
These are:
-
the use of the Own Risk and Solvency Assessment (ORSA)
-
Solvency II public disclosure, and
-
the creation of a more consumer-centric culture
Challenge 1: The use of the Own Risk and Solvency Assessment
(ORSA)
A crucial element in Solvency II is the new risk management requirements
and, in particular, the Own Risk and Solvency Assessment (ORSA).
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Insurance undertakings should make full use of the ORSA to set up a strong
risk culture.
Insurers should increasingly use robust risk management capabilities to
deal with the different challenges posed by the economic slowdown, the low
interest rate environment, the financial market volatility and the stress on
sovereign debt.
But the time of “box ticking” is over.
Risk management requirements and specifically the ORSA cannot be taken
as a compliance exercise.
This requires a clear tone from the top.
We expect Boards of insurance companies to set, communicate and enforce
a risk culture that consistently influences, directs and aligns with the
strategy and objectives of the business and thereby supports the embedding
of its risk management framework and processes. Supervisors will need to
be very attentive to this issue.
Challenge 2: Solvency II public disclosure
One of the cornerstones of the new regime is transparency.
With Solvency II undertakings need to publically disclose essential
information on their solvency and financial condition.
For most parts of the European insurance and reinsurance market
this is a novelty and a paradigm shift in terms of communication with the
outside world.
This should be used as an opportunity.
An opportunity to address stakeholders' perception on perceived
opaqueness and inadequacy of publically disclosed information.
We encourage insurance and reinsurance undertakings to embrace this
opportunity and to actively engage in consistent, comparable and high
quality communication with their stakeholders on their solvency and
financial condition.
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Here I would also like to highlight the importance of a good understanding
of the Solvency II disclosure by those who shape the public and market
opinion about companies – financial analysis, researchers and journalists.
A collective effort is needed to ensure that the Solvency II metrics and their
sensitivities are properly understood, in particular because they will be
more volatile than in the past.
Challenge 3 – creating a consumer-centric culture
The new governance requirements as a paradigm shift towards a more
consumercentric culture.
There is a need to better integrate conduct of business concerns in the
institutional governance arrangements in order to ensure that companies
reliably place the interest of their customers at the heart of their business.
But it is not only about designing and putting in practice appropriate
governance structures and controls.
It is now time to ensure that they are effective and that they deliver the
desired outcomes.
We do not want a move to a culture of formal compliance; rather we all
need to promote a culture based on strong ethical values.
When putting in practice the fundamental sound governance basis of
Solvency II, special attention should be devoted to the companies’
processes related to the manufacturing and distribution of products.
When designing products, insurers have to identify the target market of the
product, analyse its characteristics and ensure that the product meets the
identified objectives and interests of that target market.
The distribution channels selected also have to be appropriate for the target
market and clear, accurate and up-to-date information has to be disclosed
to distributors.
In effect, companies need to establish processes so that they and their
senior management and boards can take more responsibility for ensuring
their products are only sold to those they are designed for. Consumers need
to be placed at the heart of companies’ business.
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This is good for consumers and good for the business.
The review of Solvency II
Now that Solvency II is in place we need a period of stability of the
regulatory framework.
But financial regulation and supervision cannot exist independently from
economic reality.
A sound process of post-evaluation of the new regime is an integral
part of good regulation.
Therefore, the foreseen review is a logical and reasonable way forward.
EIOPA is already preparing the relevant project plans in order to ensure
a rigorous, evidence-based and transparent review of the framework.
Our work will assess possible cumulative effects and unintended
consequences, privileging principles like simplicity and proportionality.
Special attention will be given to procyclicality and effects on insurance
investment behaviour and product availability to consumers.
From this year till 2020 EIOPA will perform a yearly assessment of the
implementation of the long-term guarantee measures.
By 2018 we need to revisit the calibration of different asset classes under
Solvency II, and this should include sovereign bonds.
The recent financial crisis has demonstrated to all of us that sovereign
bonds are not always risk-free.
So, a risk-based regulatory framework should take this into account.
In April 2015 EIOPA issued an Opinion on the preparation for Internal
Model applications, recommending that risks related to sovereign
exposures should be appropriately taken into account in internal models.
Going forward, we will monitor the practical implementation by the
insurance market in the European Union.
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The subject of a possible consideration of sovereign risk in the Pillar 1
standard formula is a more complex one.
In my opinion, to avoid regulatory arbitrage, it is particularly important
that we work on an approach towards sovereign risks that is consistent for
the entire financial sector, covering banking and insurance.
Moreover, from a prudential perspective, I believe that the regulatory
treatment should focus on building appropriate incentives to avoid
excessive concentration on a specific sovereign.
This work should be part of a comprehensive process that includes public
consultation, a rigorous impact assessment and the definition of
appropriate transition measures to avoid unintended consequences.
Furthermore, the future review of Solvency II should also benefit from the
progress achieved at an international level.
EIOPA will continue to give the European Union a strong voice in
international fora and will further strengthen its successful participation in
the development of the insurance International Capital Standards.
Conclusion
Solvency II represents an enormous opportunity to improve risk
management, embed a risk culture in the organisations and develop
sustainable business models putting customers at the centre of the
undertaking’s strategy.
It also creates an opportunity to improve the functioning of the internal
market, in particular by ensuring a high, effective and consistent level of
supervision, preventing supervisory arbitrage, guaranteeing a level playing
field and ensuring a similar level of protection to all policyholders.
I am confident that if both the insurance market and supervisors remain
faithful to the sound, basic principles of the Solvency II framework, the
results for enhanced consumer protection and financial stability will be very
positive.
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Raising standards in Malaysia's financial services
industry
Dr Zeti Akhtar Aziz, Governor of the Central Bank of
Malaysia (Bank Negara Malaysia), at the Centre of
Excellence (ACE) Ground Breaking Ceremony, Kuala
Lumpur
It is my very great pleasure to be here on the occasion of the ground
breaking ceremony to the ACE - A Centre of Excellence.
ACE is a very much welcomed industry led initiative to raise the level of
capability and professionalism for the work force in the Malaysian financial
services industry.
Our financial services industry continues to be reshaped and transformed
by several major forces of change that range from the new demands of
consumers and businesses to the rapid advancement in technology, the
global regulatory reforms and the continued globalisation of finance.
On the domestic front we are also seeing the continued rapid expansion of
the domestic financial services industry, and the deepening of regional
economic and financial integration.
Given the paramount role of the financial system in supporting our real
economy we require a financial system that will best serve our economy.
It not only needs to be effective and efficient and thus competitive but also
robust and resilient.
Going forward, operating in this highly dynamic environment will become
increasingly more challenging.
Today the Malaysian financial industry employs more than 150,000 people,
and requires approximately 73,000 new hires over the next 10 years.
With the changes that are reshaping the financial system, skills
requirements in the financial industry will also change.
Today new careers are also being created in more diverse areas including in
areas of finance that have leveraged on technology such as in internet based
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services.
Further challenges will arise from the intensification of competition for
talent in a more borderless workplace.
Given the importance of talent to performance greater attention needs to be
accorded to talent development.
There also continues to be an acute talent shortage of such skilled talent in
our financial services industry.
If left unresolved it will impede future growth and performance of the
industry.
This existing significant skills gap is already becoming a constraint on
industry growth.
Indicators from the AIF Skills Gap Index, which measures skills gaps within
the workforce, point to a significant deficit in several skill sets that are
considered important in the financial services industry.
The creation of ACE represents an important step in efforts to provide a
comprehensive and integrated solution for such skills and talent
development for the industry.
At the executive level, leadership, corporate governance and ethics are
issues that have dominated attention in global finance given the need to
recognise the importance of sustainable outcomes.
There are high expectations of the financial industry to demonstrate
responsible leadership that will also embrace a strong moral compass in its
operations.
Education and professional development have a key role in bringing to the
forefront these important issues for the industry.
The establishment of ACE will support and indeed, further propel efforts to
raise the calibre and dynamism of talent across all levels in the industry.
ACE will provide a range of facilities for professional development and
skills development including learning and training for all the different
levels of financial specialisation.
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The institutions that are to be housed within ACE have all embarked on
measures to deliver programmes and qualifications that are benchmarked
against leading education and training standards.
The high quality talent that ACE will develop will contribute to the vibrancy
and progress of the Malaysian financial industry.
ACE is an initiative spearheaded by the financial services industry and it
will house 10 institutions, involved in education, training and standard
setting.
With its strategic location in Kuala Lumpur, ACE has close proximity to the
headquarters of financial institutions.
Its integrated facilities will foster and facilitate collaboration amongst
banking, insurance, capital market and Islamic finance industries to share
intellectual capital, expert resources as well as benefit from economies of
scale by the sharing of common infrastructure and facilities.
Today's ground breaking ceremony marks the official start of the
construction for the ACE project.
Let me take this opportunity to congratulate those involved in the Project to
bring it to this stage of development.
In particular, I would like to recognise the pivotal role played by the Asian
Institute of Finance, the Asian Institute of Chartered Bankers, and the
heads of the affiliate institutions, for their commitment and dedication in
taking this ACE project forward as part of key infrastructure in skills and
professional development and standards in the financial services industry.
It is a significant milestone in transforming the financial education
landscape for the financial services industry.
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Trusted Geolocation in the Cloud:
Proof of Concept Implementation
Michael Bartock, Murugiah Souppaya
Raghuram Yeluri, Uttam Shetty
James Greene, Steve Orrin, Hemma Prafullchandra, John McLeese, Jason
Mills, Daniel Carayiannis, Tarik Williams, Karen Scarfone
Reports on Computer Systems Technology
The Information Technology Laboratory (ITL) at the National Institute of
Standards and Technology (NIST) promotes the U.S. economy and public
welfare by providing technical leadership for the Nation’s measurement
and standards infrastructure.
ITL develops tests, test methods, reference data, proof of concept
implementations, and technical analyses to advance the development and
productive use of information technology.
ITL’s responsibilities include the development of management,
administrative, technical, and physical standards and guidelines for the
cost-effective security and privacy of other than national security-related
information in Federal information systems.
Abstract
This publication explains selected security challenges involving
Infrastructure as a Service (IaaS) cloud computing technologies and
geolocation.
It then describes a proof of concept implementation that was designed to
address those challenges.
The publication provides sufficient details about the proof of concept
implementation so that organizations can reproduce it if desired.
The publication is intended to be a blueprint or template that can be used
by the general security community to validate and implement the described
proof of concept implementation.
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Acknowledgments
The authors wish to thank their colleagues who reviewed drafts of this
document and contributed to its technical content, in particular Kevin Fiftal
from Intel Corporation.
Audience
This document has been created for security researchers, cloud computing
practitioners, system integrators, and other parties interested in techniques
for solving the security problem in question: improving the security of
virtualized infrastructure cloud computing technologies by enforcing
geolocation restrictions.
Trademark Information
All registered trademarks or trademarks belong to their respective
organizations.
1 Introduction
1.1 Purpose and Scope
This publication explains selected security challenges involving
Infrastructure as a Service (IaaS) cloud computing technologies and
geolocation.
It then describes a proof of concept implementation that was designed to
address those challenges.
The publication provides sufficient details about the proof of concept
implementation so that organizations can reproduce it if desired.
The publication is intended to be a blueprint or template that can be used
by the general security community to validate and implement the described
proof of concept implementation.
It is important to note that the proof of concept implementation presented
in this publication is only one possible way to solve the security challenges.
It is not intended to preclude the use of other products, services,
techniques, etc. that can also solve the problem adequately, nor is it
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intended to preclude the use of any cloud products or services not
specifically mentioned in this publication.
1.2 Document Structure
This document is organized into the following sections and appendices:
• Section 2 defines the problem (usage scenario) to be solved.
• Sections 3, 4, and 5 describe the three stages of the proof of concept
implementation.
• Appendix A provides an overview of the high-level hardware architecture
of the proof of concept implementation, as well as details on how Intel
platforms implement hardware modules and enhanced hardware-based
security functions.
• Appendix B contains supplementary information provided by HyTrust
describing all the required components and steps required to setup the
proof of concept implementation.
• Appendix C contains supplementary information provided by Intel
describing all the required components and steps required to setup the
proof of concept implementation.
• Appendix D presents screen shots from the HyTrust CloudControl product
that demonstrate the monitoring of measurements in a governance, risk,
and compliance dashboard.
• Appendix E presents screen shots from the RSA Archer product that
demonstrate the monitoring of measurements in a governance, risk, and
compliance dashboard.
• Appendix F lists the major controls from NIST Special Publication 800-53
Revision 4, Security and Privacy Controls for Federal Information Systems
and Organizations that affect trusted geolocation.
• Appendix G maps the major security features from the proof of concept
implementation to the corresponding subcategories from the Cybersecurity
Framework.
• Appendix H lists and defines acronyms and other abbreviations used in
the document.
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• Appendix I provides references for the document.
2 Usage Scenario
This section defines the problem—the usage scenario—that is to be solved
through the proof of concept implementation.
Section 2.1 explains the basics of the problem.
Section 2.2 defines the problem more formally, outlining all of the
intermediate requirements (goals) that must be met in order to achieve the
desired solution.
These requirements are grouped into three stages of the usage scenario,
each of which is examined more closely in Sections 2.2.1 through 2.2.3,
respectively.
2.1 Problem to Address
Shared cloud computing technologies are designed to be highly agile and
flexible, transparently using whatever resources are available to process
workloads for their customers.
However, there are security and privacy concerns with allowing
unrestricted workload migration.
Whenever multiple workloads are present on a single cloud server, there is
a need to segregate those workloads from each other so that they do not
interfere with each other, gain access to each other’s sensitive data, or
otherwise compromise the security or privacy of the workloads.
Imagine two rival companies with workloads on the same server; each
company would want to ensure that the server can be trusted to protect
their information from the other company.
Similarly, a single organization might have multiple workloads that need to
be kept separate because of differing security requirements and needs for
each workload.
Another concern with shared cloud computing is that workloads could
move from cloud servers located in one country to servers located in
another country.
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Each country has its own laws for data security, privacy, and other aspects
of information technology (IT).
Because the requirements of these laws may conflict with an organization’s
policies or mandates (e.g., laws, regulations), an organization may decide
that it needs to restrict which cloud servers it uses based on their location.
A common desire is to only use cloud servers physically located within the
same country as the organization, or physically located in the same country
as the origin of the information.
Determining the approximate physical location of an object, such as a cloud
computing server, is generally known as geolocation.
Geolocation can be accomplished in many ways, with varying degrees of
accuracy, but traditional geolocation methods are not secured and they are
enforced through management and operational controls that cannot be
automated and scaled.
Therefore, traditional geolocation methods cannot be trusted to meet cloud
security needs.
The motivation behind this usage scenario is to improve the security of
cloud computing and accelerate the adoption of cloud computing
technologies by establishing an automated hardware root of trust method
for enforcing and monitoring geolocation restrictions for cloud servers.
A hardware root of trust is an inherently trusted combination of hardware
and firmware that maintains the integrity of the geolocation information
and the platform.
The hardware root of trust is seeded by the organization, with the host’s
unique identifier and platform metadata stored in tamper-resistant
hardware.
This information is accessed by management and security tools using
secure protocols to assert the integrity of the platform and confirm the
location of the host.
2.2 Requirements
Using trusted compute pools (described in Section 3) is a leading approach
to aggregate trusted systems and segregate them from untrusted resources,
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which results in the separation of higher-value, more sensitive workloads
from commodity application and data workloads.
The principles of operation are to:
1. Create a part of the cloud to meet the specific and varying security
requirements of users.
2. Control access to that portion of the cloud so that the right applications
(workloads) get deployed there.
3. Enable audits of that portion of the cloud so that users can verify
compliance.
These trusted compute pools allow IT to gain the benefits of the dynamic
cloud environment while still enforcing higher levels of protections for their
more critical workloads.
The ultimate goal is to be able to use trusted geolocation for deploying and
migrating cloud workloads between cloud servers within a cloud.
This goal is dependent on smaller prerequisite goals, which can be thought
of as requirements that the solution must meet.
Because of the number of prerequisites, they have been grouped into three
stages:
Platform Attestation and Safer Hypervisor Launch. This ensures that the
cloud workloads are run on trusted server platforms.
Trust-Based Homogeneous Secure Migration. This stage allows cloud
workloads to be migrated among homogeneous trusted server platforms
within a cloud.
Trust-Based and Geolocation-Based Homogeneous Secure Migration.
This stage allows cloud workloads to be migrated among homogeneous
trusted server platforms within a cloud, taking into consideration
geolocation restrictions.
The prerequisite goals for each stage, along with more general information
on each stage, are explained below.
2.2.1 Stage 0: Platform Attestation and Safer Hypervisor Launch
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A fundamental component of a solution is having some assurance that the
platform the workload is running on can be trusted.
If the platform is not trustworthy, then not only is it putting the workload at
greater risk of compromise, but also there is no assurance that the claimed
geolocation of the cloud server is accurate.
Having basic assurance of trustworthiness is the initial stage in the
solution.
Stage 0 includes the following prerequisite goals:
1. Configure a cloud server platform as being trusted.
The “cloud server platform” includes the hardware configuration (e.g.,
Basic Input/Output System (BIOS ) settings) and the hypervisor
configuration.
(This assumes that the hypervisor is running directly on the hardware, and
not on top of another operating system.
This also assumes that the hypervisor has not been compromised and that
the hypervisor is the designated version.)
2. Before each hypervisor launch, verify (measure) the trustworthiness of
the cloud server platform.
The items configured in goal 1 (BIOS and hypervisor) need to have their
configurations verified before launching the hypervisor to ensure that the
assumed level of trust is still in place.
3. During hypervisor execution, periodically audit the trustworthiness of
the cloud server platform.
This periodic audit is essentially the same check as that performed as goal
2, except that it is performed frequently while the hypervisor is executing.
Ideally this checking would be part of continuous monitoring.
Achieving all of these goals will not prevent attacks from succeeding, but
will cause unauthorized changes to the hypervisor or BIOS to be detected
much more rapidly than they otherwise would have been.
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So if a hypervisor is tampered with or subverted, the alteration will be
detected quickly, almost instantly if continuous monitoring is being
performed.
This allows an immediate stop to execution, thus limiting damage to the
information being processed within the cloud computing server.
For more information on the technical topics being addressed by these
goals, see the following NIST publications:
• NIST Special Publication (SP) 800-125, Guide to Security for Full
Virtualization Technologies
http://csrc.nist.gov/publications/PubsSPs.html#800-125
• NIST SP 800-128, Guide for Security-Focused Configuration
Management of Information Systems
http://csrc.nist.gov/publications/PubsSPs.html#800-128
• NIST SP 800-137, Information Security Continuous Monitoring for
Federal Information Systems and Organizations
http://csrc.nist.gov/publications/PubsSPs.html#800-137
• NIST SP 800-144, Guidelines on Security and Privacy in Public Cloud
Computing http://csrc.nist.gov/publications/PubsSPs.html#800-144
• NIST SP 800-147B, BIOS Protection Guidelines for Servers
http://csrc.nist.gov/publications/PubsSPs.html#SP-800-147-B
• Draft NIST SP 800-155, BIOS Integrity Measurement Guidelines
http://csrc.nist.gov/publications/PubsSPs.html#800-155
2.2.2 Stage 1: Trust-Based Homogeneous Secure Migration
Once stage 0 has been successfully completed, the next objective is to be
able to migrate workloads among homogeneous, trusted platforms.
Workload migration is a key attribute of cloud computing, improving
scalability and reliability.
The purpose of this stage is to ensure that any server that a workload is
moved to will have the same level of security assurance as the server it was
initially deployed to.
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Stage 1 includes the following prerequisite goals:
1. Deploy workloads only to cloud servers with trusted platforms.
This basically means that you perform stage 0, goal 3 (auditing platform
trustworthiness during hypervisor execution) and only deploy a workload
to the cloud server if the audit demonstrates that the platform is
trustworthy.
2. Migrate workloads on trusted platforms to homogeneous cloud servers
on trusted platforms; prohibit migration of workloads between trusted and
untrusted servers.
For the purposes of this publication, homogeneous cloud servers are those
that have the same hardware architecture (e.g., Central Processing Unit
(CPU) type) and the same hypervisor type, and that reside in the same
cloud with a single management console.
If a workload has been deployed to a trusted platform, the level of assurance
can only be sustained if it is migrated only to hosts with comparable trust
levels.
So this goal is built upon stage 0, goal 3 (auditing platform trustworthiness
during hypervisor execution) performed on both the workload’s current
server and the server to migrate the workload to.
Only if both servers pass their audits can the migration be permitted to
occur.
Achieving these goals ensures that the workloads are deployed to trusted
platforms, thus reducing the chance of workload compromise.
For more information on the technical topics being addressed by these
goals, see the following NIST publications:
• NIST SP 800-137, Information Security Continuous Monitoring for
Federal Information Systems and Organizations
http://csrc.nist.gov/publications/PubsSPs.html#800-137
• NIST SP 800-144, Guidelines on Security and Privacy in Public Cloud
Computing http://csrc.nist.gov/publications/PubsSPs.html#800-144
• NIST SP 800-147B, BIOS Protection Guidelines for Servers
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http://csrc.nist.gov/publications/PubsSPs.html#SP-800-147-B
• Draft NIST SP 800-155, BIOS Integrity Measurement Guidelines
http://csrc.nist.gov/publications/PubsSPs.html#800-155
2.2.3 Stage 2: Trust-Based and Geolocation-Based Homogeneous
Secure Migration
The next stage builds upon stage 1 by adding the ability to continuously
monitor and enforce geolocation restrictions.
Stage 2 includes the following prerequisite goals:
1. Have trusted geolocation information for each trusted platform instance.
This information would be stored within the cloud server’s cryptographic
module (as a cryptographic hash within the hardware cryptographic
module), so that it could be verified and audited readily.
2. Provide configuration management and policy enforcement mechanisms
for trusted platforms that include enforcement of geolocation restrictions.
This goal builds upon stage 1, goal 2 (migrating workloads on trusted
platforms to other trusted platforms); it enhances stage 1, goal 2 by adding
a geolocation check to the server to migrate the workload to.
3. During hypervisor execution, periodically audit the geolocation of the
cloud server platform against geolocation policy restrictions.
This goal is built upon stage 0, goal 3 (auditing platform trustworthiness
during hypervisor execution), but it is specifically auditing the geolocation
information against the policies for geolocation to ensure that the server’s
geolocation does not violate the policies.
Achieving these goals ensures that the workloads are not transferred to a
server in an unsuitable geographic location.
This avoids issues caused by clouds spanning different physical locations
(e.g., countries or states with different data security and privacy laws).
For more information on the technical topics being addressed by these
goals, see the following NIST publications:
• NIST SP 800-128, Guide for Security-Focused Configuration
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Management of Information Systems
http://csrc.nist.gov/publications/PubsSPs.html#800-128
• NIST SP 800-137, Information Security Continuous Monitoring for
Federal Information Systems and Organizations
http://csrc.nist.gov/publications/PubsSPs.html#800-137
• NIST SP 800-147B, BIOS Protection Guidelines for Servers
http://csrc.nist.gov/publications/PubsSPs.html#SP-800-147-B
• Draft NIST SP 800-155, BIOS Integrity Measurement Guidelines
http://csrc.nist.gov/publications/PubsSPs.html#800-155
3 Usage Scenario Instantiation Example: Stage 0
This section describes stage 0 of the proof of concept implementation
(platform attestation and safer hypervisor launch).
3.1 Solution Overview
This stage of the usage scenario enables the creation of what are called
trusted compute pools.
Also known as trusted pools, they are physical or logical groupings of
computing hardware in a data center that are tagged with specific and
varying security policies, and the access and execution of apps and
workloads are monitored, controlled, audited, etc.
In this phase of the solution, an attested launch of the platform including
the hypervisor is deemed as a trusted node, and is added to the trusted
pool.
Figure 1 depicts the concept of trusted pools.
The resources tagged green indicate trusted ones.
Critical policies can be defined such that security-sensitive cloud services
can only be launched on these trusted resources, or migrated to other
trusted platforms within these pools.
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Figure 1: Concept of Trusted Pools
In order to have a trusted launch of the platform, the two key questions that
should be answered are:
1. How would the entity needing this information know if a specific
platform has the necessary enhanced hardware-based security features
enabled and if a specific platform has a defined/compliant operating
system (OS)/virtual machine manager (VMM) running on it?
2. Why should the entity requesting this information, which in a cloud
environment would be a scheduler/orchestrator trying to schedule a
workload on a set of available nodes/servers, believe the response from the
platform?
Attestation provides the definitive answers to these questions.
Attestation is the process of providing a digital signature of a set of
measurements securely stored in hardware, then having the requestor
validate the signature and the set of measurements.
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Attestation requires roots of trust.
The platform has to have a Root of Trust for Measurement (RTM) that is
implicitly trusted to provide an accurate measurement, and enhanced
hardware-based security features provide the RTM.
The platform also has to have a Root of Trust for Reporting (RTR) and a
Root of Trust for Storage (RTS), and the same enhanced hardware-based
security features provide these.
The entity that challenged the platform for this information now can make
a determination about the trust of the launched platform by comparing the
provided set of measurements with “known good/golden” measurements.
Managing the “known good” for different hypervisors and operating
systems, and various BIOS software, and ensuring they are protected from
tampering and spoofing is a critical IT operations challenge.
This capability can be internal to a service provider, or it could be delivered
as a service by a trusted third party for service providers and enterprises to
use.
3.2 Solution Architecture
Figure 2 provides a layered view of the solution system architecture.
The indicated servers in the resource pool include a hardware module for
storing sensitive keys and measurements.
All the servers are configured by the virtualization management server.
The initial step in instantiating the architecture requires provisioning the
server for enhanced hardware- based security features.
This currently requires physical access to the server to access the BIOS,
enable a set of configuration options to use the hardware module (including
taking ownership of the module), and activate the enhanced
hardware-based security features.
This process is highly BIOS and OEM dependent.
This step is mandatory for a measured launch of the OS/hypervisor.
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Assuming that the virtual machine (VM) supports the enhanced
hardware-based security features and these features have been enabled and
a launch policy configured, the hypervisor undergoes a measured launch,
and the BIOS and VMM components are measured (cryptographically) and
placed into the server hardware module.
These measurement values are accessible through the virtualization
management server via the Application Program Interface (API).
When the hosts are initially configured with the virtualization management
server, the relevant measurement values are cached in the virtualization
management database.
In addition to the measured launch, this solution architecture also provides
provisions to assign a secure geolocation tag (geotag) to each of the servers
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during the provisioning process.
The geotag is provisioned to a non-volatile index in the hardware module
via an out-of-band mechanism, and on a hypervisor launch, the contents of
the index are inserted/extended into the hardware module.
Enhanced hardware- based security features provide the interface and
attestation to the geotag information, including the geotag lookup and
user-readable/presentable string/description.
4 Usage Scenario Instantiation Example: Stage 1
This section discusses stage 1 of the proof of concept implementation
(trust-based homogeneous secure migration), which is based on the stage 0
work and adds components that migrate workloads among homogeneous,
trusted platforms.
4.1 Solution Overview
Figure 3 shows the operation of the stage 1 solution. It assumes that Server
A and Server B are two servers within the same cloud.
Figure 3: Stage 1 Solution Overview
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There are five generic steps performed in the operation of the stage 1
solution, as outlined below and reflected by the numbers in Figure 3:
1. Server A performs a measured launch, with the enhanced
hardware-based security features populating the measurements in the
hardware module.
2. Server A sends a quote to the Trust Authority. The quote includes signed
hashes of the BIOS, Trusted Boot (TBOOT), VM, and geotag values.
3. The Trust Authority verifies the signature and hash values and sends an
authorization token to Server A.
4. Server A’s management layer executes a policy-based action (in this case,
a VM transfer to Server B).
5. Server A and Server B get audited periodically based on their
measurement values.
4.2 Solution Architecture
The stage 1 architecture is identical to the stage 0 architecture (see Figure
2), with additional measurement occurring related to the migration of
workloads among trusted hosts.
5 Usage Scenario Instantiation Example: Stage 2
This section discusses stage 2 of the proof of concept implementation
(trust-based and geolocation-based homogeneous secure migration), which
is based on the stage 1 work and adds components that take into account
geolocation restrictions.
5.1 Solution Overview
Stage 2 adds the monitoring of measurements in a governance, risk, and
compliance dashboard.
One chart that might appear in such a dashboard could reflect the relative
size of the pools of trusted and untrusted cloud servers.
This could be displayed by percentage and/or count.
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Figure 4 shows a notional example.
Table 1 is a drill-down page from the high-level dashboard view shown in
Figure 4.
It provides more details on all the servers within the cloud.
In this example, there are three servers.
Information listed for each server includes the server’s IP address, the
status of the three measurements (trusted boot validation, geolocation
validation, and system validation), and the timestamp for when those
measurements were taken.
Figure 5 shows a drill-down from Table 1 for an individual server.
It includes the raw measurement data for the trusted boot validation and
the geolocation validation, alongside the “golden values” that the trusted
boot value and geolocation value are expected to have.
It also shows when the server was first measured and when it was most
recently measured.
Measuring each server’s characteristics frequently (such as every five
minutes) helps to achieve a continuous monitoring solution for the servers.
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5.2 Solution Architecture
The stage 2 architecture is identical to the stage 0 and stage 1 architectures
(see Figure 2), with additional reporting and monitoring occurring related
to geolocation.
Appendix A—Hardware Architecture and Prerequisites
This appendix provides an overview of the high-level hardware architecture
of the proof of concept implementation, as well as details on how Intel
platforms implement hardware modules and enhanced hardware-based
security functions.
A.1 High-Level Implementation Architecture
Following the recommendations proposed in NIST SP 800-125, the
high-level architecture of the proof of concept implementation is composed
of three distinct networks to isolate the traffic flowing through the
management VMs, storage device, and public VMs.
Figure 6 represents the proof of concept implementation architecture,
which includes the various hardware and logical networks.
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Management Network
The management workstation is connected to the management network,
which includes the four management servers.
A dedicated server is used to host the management VMs for the other
management servers: the cloud orchestration server, the trust authority
server, and the audit and reporting server.
The cloud orchestration server manages the remaining three servers, which
are part of the cluster hosting the public VMs.
The measurement server takes measurements of the trusted cloud cluster
and directs them to the cloud orchestration server.
The audit and reporting server communicates with the cloud orchestration
server to obtain the measurement values to reflect in the dashboard view.
The management network is connected to a dedicated non-routable
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network.
An additional non-routable network is used to support the automated
migration of the VMs from different nodes across the trusted cluster.
Storage Network
The storage device provides shared storage where the public VMs are
hosted. The three public VM servers are connected to the storage network,
which uses a non-routable network.
Public VM Network
The public VM network is accessible to the workload owners from the
Internet.
In the demonstration, a single server represents a typical public workload
VM controlled by the customers over the Internet.
A dedicated network card on each of the trusted cluster server nodes is used
to carry the VM’s traffic.
A.2 Intel Trusted Execution Technology (Intel TXT) & Trusted
Platform Module (TPM)
Hardware-based root of trust, when coupled with an enabled operating
system, hypervisor and solutions, constitutes the foundation for a more
secure computing platform.
This secure platform ensures OS and VMM integrity at boot from rootkits
or other low-level attacks.
It establishes the trustworthiness of the server and host platforms.
There are three roots of trust in a trusted platform:
• Root of trust for measurement (RTM)
• Root of trust for reporting (RTR)
• Root of trust for storage (RTS)
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RTM, RTR, and RTS are the foundational elements of a single platform.
These are the system elements that must be trusted because misbehavior in
these normally would not be detectable in the higher layers.
In an Intel TXT-enabled platform the RTM is the Intel microcode.
This is the Core-RTM (CRTM). An RTM is the first component to send
integrity-relevant information (measurements) to the RTS.
Trust in this component is the basis for trust in all the other measurements.
RTS contains the component identities (measurements) and other sensitive
information.
A trusted platform module (TPM) provides the RTS and RTR capabilities in
a trusted computing platform.
Intel Trusted Execution Technology (Intel TXT) is the RTM, and it is a
mechanism to enable visibility, trust, and control in the cloud.
Intel TXT is a set of enhanced hardware components designed to protect
sensitive information from software-based attacks.
Intel TXT features include capabilities in the microprocessor, chipset, I/O
subsystems, and other platform components.
When coupled with an enabled operating system, hypervisor, and enabled
applications, these capabilities provide confidentiality and integrity of data
in the face of increasingly hostile environments.
Intel TXT incorporates a number of secure processing innovations,
including:
• Protected execution.
Lets applications run in isolated environments so that no unauthorized
software on the platform can observe or tamper with the operational
information.
Each of these isolated environments executes with the use of dedicated
resources managed by the platform.
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• Sealed storage.
Provides the ability to encrypt and store keys, data, and other sensitive
information within the hardware.
This can only be decrypted by the same environment that encrypted it.
• Attestation.
Enables a system to provide assurance that the protected environment has
been correctly invoked and to take a measurement of the software running
in the protected space.
The information exchanged during this process is known as the attestation
identity key credential and is used to establish mutual trust between
parties.
• Protected launch.
Provides the controlled launch and registration of critical system software
components in a protected execution environment.
Intel Xeon processor 5600 series and the more recent Xeon Processor E3,
Xeon Processor E7, and forthcoming Xeon Processor E5 series processors
support Intel TXT.
Figure 7 depicts the different hardware and software components that Intel
TXT is comprised of. Intel TXT works through the creation of a measured
launch environment (MLE) enabling an accurate comparison of all the
critical elements of the launch environment against a known good source.
Intel TXT creates a cryptographically unique identifier for each approved
launch-enabled component and then provides a hardware-based
enforcement mechanism to block the launch of any code that does not
match or, alternately, indicate when an expected trusted launch has not
happened.
This hardware-based solution provides the foundation on which IT
administrators can build trusted platform solutions to protect against
aggressive software-based attacks and to better control their virtualized or
cloud environments.
Figure 8 illustrates two different scenarios.
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In the first, the measurements match the expected values, so the launch of
the BIOS, firmware, and VMM is allowed.
In the second, the system has been compromised by a rootkit (malicious
hypervisor), which attempts to install itself below the hypervisor to gain
access to the platform.
In this case, the Intel TXT-enabled, MLE-calculated hash system
measurement will differ from the expected value due to the insertion of the
rootkit.
Therefore, based on the launch policy, Intel TXT could abort the launch of
the hypervisor or report an untrusted launch to the virtualization or cloud
management infrastructure for subsequent use.
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A.3 Attestation
There are two main considerations for usage scenarios to be instantiated
and delivered in a cloud:
• How would the entity needing this information know if a specific platform
has Intel TXT enabled or if a specific server has a defined or compliant
BIOS or OS running on it (i.e., can it be trusted)?
• Why should the entity requesting this information (which, in a cloud
environment, could be a resource scheduler or orchestrator trying to
schedule a service on a set of available nodes or servers) trust the response
from the platform?
An attestation authority provides the definitive answers to these questions.
Attestation up-levels the notion of roots of trust by making the information
from various roots of trust visible and usable by other entities.
Figure 9 illustrates the attestation protocol providing the means for
conveying measurements to the challenger.
The endpoint attesting device must have a means of measuring the BIOS
firmware, low level device drivers, and operating system and virtual
machine monitor components, and forwarding those measurements to the
attestation authority.
The attesting device must do this while protecting the integrity,
authenticity, nonrepudiation, and in some cases, confidentiality of those
measurements.
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Here are the steps shown in Figure 9 for the remote attestation protocol:
• In step 1, the challenger, at the request of a requester, creates a
non-predictable nonce (NC) and sends it to the attestation agent on the
attesting node, along with the selected list of Platform Configuration
Registers (PCRs).
• In step 2, the attestation agent sends that request to the TPM as a
TPMQuoteRequest with the nonce and the PCR List.
• In step 3, in response to the TPMQuote request, the TPM loads the
attestation identity key from protected storage in the TPM by using the
storage root key (SRK), and performs a TPM Quote command, which is
used to sign the selected PCRs and the provided nonce (NC) with the
private key AIKpriv.
Additionally, the attesting agent retrieves the stored measurement log
(SML).
• In step 4, the integrity response step, the attesting agent sends the
response consisting of the signed quote, signed nonce (NC), and the SML to
the challenger.
The attesting agent also delivers the Attestation Identity Key (AIK)
credential, which consists of the AIKpub that was signed by a privacy
Certificate Authority (CA).
• In step 5a, the challenger validates if the AIK credential was signed by a
trusted privacy CA, thus belonging to a genuine TPM.
The challenger also verifies whether AIKpub is still valid by checking the
certificate revocation list of the trusted issuing party.
• In step 5b, the challenger verifies the signature of the quote and checks the
freshness of the quote.
• In step 5c, based on the received SML and the PCR values, the challenger
processes the SML, compares the individual module hashes that are
extended to the PCRs against the “good known or golden values,” and
recomputes the received PCR values.
If the individual values match the golden values and if the computed values
match the signed aggregate, the remote node is asserted to be in a trusted
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state.
This protocol is highly resistant against replay attacks, tampering, and
masquerading.
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Economic perspectives
Annual address by Mr Øystein Olsen, Governor of the
Norges Bank (Central Bank of Norway), to the
Supervisory Council of Norges Bank and invited
guests, Oslo
Introduction
In late autumn 1857, a steamship left Christiania bound for Hamburg
carrying a cargo of silver from Norges Bank to be deposited in one of
Hamburg’s finance houses.
In only a few months, 20 tonnes of silver worth 800 000 speciedaler were
shipped south as collateral for the redemption into silver of bills and notes
issued by Norges Bank.
There was to be no doubt that the speciedaler was worth its face value in
silver.
Europe had just been hit by a financial crisis.
Norges Bank intervened to maintain confidence in the country’s currency.
The Bank remained faithful to the social mission it had been assigned 40
years earlier.
This year is Norges Bank’s 200th anniversary.
Under the Constitution, control of the monetary system was given to the
Storting (Norwegian parliament).
The establishment of Norges Bank in 1816 gave the authorities a tool to
restore confidence in the country’s means of payment.
Norges Bank had a monopoly on the issuance of currency, but the amount
of currency in circulation was limited by the stock of silver.
The organisation of Norway’s monetary system was inspired by the
note-issuing banks that had emerged in Europe since the end of the 1600s.
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One hard-won lesson was particularly important: the central bank must
keep the crown and government at arm’s length and must not extend credit
to government.
Control of the printing press would promote economic stability and prevent
unrestrained money printing to finance spending by the crown.
Two hundred years later, safeguarding the value of money remains
monetary policy’s main task.
Responsibility for monetary policy rests with Norges Bank, but today policy
is geared towards maintaining stable inflation rather than a stable currency
backed by a precious metal.
The Bank’s role has also changed in other areas.
From being the country’s only bank, Norges Bank took on the role of the
bankers’ bank, with the new responsibilities that entailed.
The central bank also has a responsibility to promote robust financial
markets.
The core of Norway’s payment system is housed in this building.
Two hundred years as a central bank in a small open economy
The Norwegian economy has changed over the past 200 years.
In the early 1800s, eight in ten Norwegians worked in agriculture, forestry
and fisheries compared with one in forty today.
But some important features have not changed.
Norway is a small open economy and developments abroad have an impact
at home.
Our foreign trade is largely based on natural resources.
In the early 1800s, fish, timber and shipping were the mainstays of our
economy.
In recent times, oil and gas sales have accounted for a large share of
Norway’s export revenues.
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With only a few large export industries, changes in Norway’s terms of trade
have a greater impact on our economy than on other economies in our
region.
In the early 2000s, international prices moved in our favour.
The fall in oil prices over the past couple of years has changed the picture.
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We are now faced with the negative implications of a largely oil- dependent
Norwegian economy.
It is not the first time Norway’s terms of trade have taken a turn for the
worse.
The same thing happened after the First World War and in the 1980s, with
severe repercussions for the Norwegian economy both times.
The experience gained from these periods has contributed to shaping
today’s monetary policy framework.
The road from the silver standard to today’s inflation targeting regime has
not been without bumps.
It is fair to say that monetary policy in the Bank’s first 100 years was fairly
successful.
The prevailing environment of hyperinflation and a loss of confidence in the
value of the currency posed a challenge, but after full silver redemption had
been established in 1842, the Bank was able to stand by its promise to
honour its own banknotes, first in silver, then in gold.
This policy had a stabilising effect on prices.
The period is referred to as the heyday of stable money.
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This period of stability came to an abrupt halt when the First World War
broke out.
The war generated substantial profits for the shipping industry and fuelled
speculative behaviour resulting in a credit and asset price boom.
Monetary policy did not contribute to dampening these developments.
There was a sharp increase in the money supply and inflation soared.
Between 1914 and 1918, the price level more than doubled.
After the war, exports fell and the krone depreciated to about half of the
statutory exchange rate.
At the same time, the economy was faced with a banking crisis and
recession.
This created a dilemma for monetary policy.
The prevailing view was nonetheless that the krone had to be brought back
to parity.
The task fell to Nicolai Rygg.
The active deflationary policy pursued proved to be costly.
However, Rygg stood firm in his belief that breaking the promise made in
1816 to preserve a stable value of money would entail more serious
consequences:
“The hardships we are facing in the transition to normal, ordered
conditions are transient.
No one can close their eyes to the fact that they are very serious, but the life
of the people is eternal and the consequences of this decision will remain
with us for generations.”
Those were Rygg’s words in his annual address in 1927.
A year later, in 1928, the policy of gold parity had achieved its objective.
Consumer prices had fallen by more than 40 percent since 1920.
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But the gold standard would only survive three years.
In the wake of the Great Depression, the UK abandoned the gold standard
and Norway followed suit.
After the Second World War, there was a substantial shift in economic
policy.
Direct regulation and an active fiscal policy were regarded as more effective
instruments than the interest rate, also in terms of promoting price
stability.
This was an international trend, but few countries supported the new
thinking more than Norway, spurred to a large extent by the negative legacy
of the policy of parity.
In practice, the interest rate was thereafter to be set by the government, and
as a main principle the interest rate was to be kept low.
Norges Bank’s discount rate was set at 2.5 percent in 1946 and was changed
only once over the next 23 years.
Credit would be channelled to promote policy priorities and kept in check
by means of regulation and foreign exchange controls.
The policy regime eventually started to falter.
In the 1970s, domestic inflation spiralled out of control, as it did in many
other countries.
In Norway, the government responded with stimulus measures, wage and
price freezes and devaluations, but the measures had limited effect.
High inflation had become entrenched.
A policy change was needed to bring down inflation.
The low interest rate policy was discontinued in the wake of the oil price
collapse in 1986.
Norges Bank was given broader responsibility for the conduct of monetary
policy.
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With freer international capital movements, the interest rate level had to be
raised substantially to defend the krone exchange rate.
In the period that followed, the Norwegian economy took a tough cure.
Unemployment reached its highest levels since the interwar years and the
banking industry was mired in problems.
The challenges of operating a fixed exchange rate regime in an oil economy
became increasingly evident.
In 1992, the policy of setting a specific target for the krone exchange rate
was abandoned.
Monetary policy would still aim to maintain exchange rate stability, but the
absence of a clear and verifiable objective was a weakness.
Internationally, a new approach to monetary policy was gaining ground.
Through the 1990s, a growing number of central banks were tasked with
pursuing the goal of low and stable inflation.
The introduction of the inflation target in 2001 was an important milestone
for Norges Bank.
The inflation target gave monetary policy an effective nominal anchor in a
world of free capital movements.
Inflation had been under control since the early 1990s and confidence in
the value of money strengthened further in the years thereafter.
Economic restructuring in Norway
During the first 15 years of inflation targeting, the Norwegian economy was
in a unique position.
But the upswing could not last forever.
The sharp fall in oil prices since summer 2014 will put the economy to the
test in the period ahead.
The Norwegian economy has enjoyed an exceptionally long summer.
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Winter is coming.
The Norwegian economy is well equipped to tackle the challenges.
The defence mechanisms of economic policy are better suited today than
when oil prices fell in the mid-1980s.
At that time, current oil revenues were largely spent over the government
budget.
When oil prices plummeted, the budget was severely tightened.
Today we have accumulated savings of more than five times the
government budget.
In the 1980s, the banks had little equity capital.
Many of them failed when faced with loan losses, which in turn amplified
the economic downturn.
In recent years, banking regulation has been enhanced.
Banks have built up their capital levels, which puts them in a better position
to fulfil their role as providers of credit during a downturn.
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Towards the end of the 1980s, both interest rates and unemployment
reached a high level at the same time.
There is little likelihood that this will happen again.
Since the inflation target was introduced, it has been easier for monetary
policy to have a countercyclical effect.
When inflation expectations are firmly anchored, monetary policy should
also be geared towards stabilising output and employment.
Inflation has been low and stable for a quarter century.
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This is now of benefit to us all.
The oil price collapse in the 1980s led to a substantial current account
deficit.
Competitiveness had to be strengthened.
In May 1986, the krone exchange rate was devalued by around 10 percent.
The repeated devaluations in the preceding years had undermined
credibility.
The gains were short-lived.
Price and wage inflation soared.
It was only after several years of high unemployment that the relative wage
level came down.
The current account deficit rapidly turned into a surplus.
The Norwegian economy grew out of recession, supported by external
growth impulses and the development of the Norwegian oil sector.
This time, we cannot rely on those sources of impetus.
The Norwegian economy will need more legs to stand on in the future.
The time to restructure has come.
A necessary adjustment of the cost level can occur via two channels, either
through lower wage growth relative to other countries or a weaker krone
exchange rate.
In the past few years, the krone exchange rate has depreciated more than in
the 1980s.
And this time, the krone depreciation has fed through to relative labour
costs in a common currency.
In a short time, the relatively high level of cost inflation over the past
decade in Norway has been wiped out.
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The main responsibility for developments in relative wages lies with the
social partners.
A durable improvement in competitiveness is dependent on Norwegian
wage earners’ willingness to accept future wage settlements without a
substantial increase in purchasing power.
This will make it easier for non-oil exposed industries to grow, which will
create new and viable jobs.
The krone depreciation has helped start the restructuring process.
After a decade of higher growth in imports than mainland exports, export
growth is now outpacing import growth.
The tourism industry is one of many industries experiencing an upswing.
Many export firms have announced plans to increase investments in 2016,
which will likely entail an increase in production and market shares.
Oil service companies are also benefitting from the krone depreciation.
So far, around 75 percent of the field development contracts for Johan
Sverdrup have been won by Norwegian companies, a clearly higher share
than in recent years.
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The effect of the sharp fall in demand from oil companies is nevertheless
predominant in the oil service industry.
Both the oil production industry and the oil service industry must now go
through a process of restructuring.
Costs at many stages appear to have followed oil prices upwards.
High prices may have created a sense of complacency.
The profits from petroleum activities have nevertheless been substantial.
Most of the economic rent has flowed into government coffers via the
special taxation of oil production.
But wages in oil production and oil services have also been relatively high.
The rise in input prices and investment in the petroleum industry have been
significantly higher than for other industries.
The excess costs have reduced the economic rent.
At today’s oil price, it seems that virtually none of the new field
developments planned on the Norwegian shelf can be realised at a profit.
But cost calculations may change.
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Oil prices are not the only prices trending downwards.
The cost level on the Norwegian shelf is also drifting down.
This is perhaps best illustrated by developments in rig rates.
The rates followed oil prices upwards, but have fallen in recent months.
At the same time, oil companies are slashing costs.
The development of the Johan Sverdrup field is now profitable even at oil
prices around USD 30 per barrel.
For the Castberg field development in the Barents Sea, the break- even
price has been reduced from more than USD 80 to below USD 45 per
barrel.
Norway’s oil age is not over.
Proven crude oil reserves are larger today than 10 years ago despite
substantial sales over the period.
Our gas resources are even larger.
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So far, only a third of the estimated exploitable Norwegian gas resources
have been produced.
Oil and gas prices will to a large extent determine the quantity that will be
extracted.
That is something we can do little about.
What we can do is to optimise production efficiency on the Norwegian shelf
as far as possible.
There is still potential in this respect.
Increased productivity and lower costs in the oil industry will contribute to
sustaining activity on the Norwegian shelf, which will also benefit the oil
service industry.
The economic rent should benefit society as far as possible.
Employment has been high in Norway for many years.
Compared with other countries, unemployment has been low.
In the competition for labour resources, oil production and oil service
companies drew the longest straw.
The situation has now changed.
Unemployment is on the rise.
Norway’s oil regions, which have long reaped the benefits of the upswing,
are now struggling.
The downswing is proving painful for many.
But the situation is far different from the adverse conditions that prevailed
in the 1980s, which resulted in a deep economic crisis in Norway.
But unemployment must be expected to be higher than we have been
accustomed to in recent years.
Closing a business takes less time than developing a new one.
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Restructuring takes time.
Restructuring must start in the business sector.
Economic policy can only help set the stage.
Monetary policy can facilitate the restructuring process by supporting a
weaker krone exchange rate and thereby expedite adaptation to a lower cost
level.
In addition, reduced interest expenses will contribute to income growth for
many households.
There is still room for manoeuvre in monetary policy.
When unemployment rises, as is the case today, it may be appropriate to
use the fiscal space available.
We must avoid a self-reinforcing decline in output and employment and
hence a decline that is more pronounced than necessary.
But an increase in the spending of petroleum revenues should primarily be
used to finance temporary measures that are easy to reverse.
Fiscal policy must also take into consideration that lower oil prices will
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reduce the government’s spending capacity in the longer term.
In recent years, we have sold large volumes of oil and gas at good prices.
The transfers to the government’s savings account have been substantial.
The picture is now quite different.
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If oil prices remain at today’s level, government revenues will fall sharply.
The present value of future income can in that case be estimated at a fourth
of today’s oil fund, the Government Pension Fund Global (GPFG).
That means that most of the government’s petroleum wealth may already
have been deposited in the GPFG.
The year 2015 may stand as the last year of net transfers to the GPFG.
Already when the budget for 2016 was presented, there were prospects that
the spending of oil revenues would exceed actual income from petroleum
activities. At today’s oil price, it may be necessary to use about NOK 80
billion of the GPFG’s return to finance the structural non-oil budget deficit.
In the course of three years, spending of oil revenues has increased by as
much as in the 10 previous years.
In the budget for 2016, spending of oil revenues is estimated at more than 7
percent of mainland GDP.
Spending is well below 4 percent of the GPFG’s value, which is the assumed
– but highly uncertain – real return.
The 4-percent fiscal rule no longer functions as an effective long-term
guideline for fiscal policy.
The fall in oil prices will reduce Norway’s national wealth.
The GPFG may be close to its peak.
Future returns are also uncertain.
Against this background, increased spending is not a viable path to follow.
Management of the Government Pension Fund Global (GPFG)
It is now 20 years since Minister of Finance Sigbjørn Johnsen made the
first capital transfer to the Government Petroleum Fund, as the
Government Pension Fund Global was aptly named at the time.
Since its establishment, NOK 3.5 trillion has been transferred to the GPFG.
GPFG capital has almost doubled, and is now the equivalent of around NOK
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1.3 million per inhabitant.
The return on investments accounts for a substantial portion, close to a
third, of GPFG capital. Nearly every year, Norges Bank’s management of
the GPFG has outperformed the market average.
It would appear that the pattern is too consistent to be due to chance.
All the key variables that are essential for the GPFG’s long-term
performance have been specified by the Ministry of Finance and approved
by the Storting, and this is how it should be.
This financial wealth belongs to the Norwegian people.
Norges Bank’s role is to manage it and to advise the Ministry of Finance on
investment strategy.
There is no return without risk.
As a long-term investor, the GPFG is especially well- positioned to weather
short-term volatility in securities markets.
This is the reason for the GPFG’s relatively high allocation to equities of 60
percent.
Rebalancing the GPFG towards a fixed equity allocation has also enabled
the GPFG to benefit from buying low and selling high. Sitting tight has been
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a profitable strategy.
The GPFG’s investment universe has been expanded to include unlisted
real estate.
Its size and long time horizon are an advantage in real estate investing.
The real estate portfolio has grown to more than NOK 200 billion.
The GPFG is becoming a big real estate investor in a number of major cities.
Norges Bank recently recommended increasing the GPFG’s real estate
allocation to between 5 and 15 percent.
We are also prepared to invest in foreign infrastructure.
The return on real estate and infrastructure tends to follow a slightly
different pattern than the return on equities and bonds.
Investing in these asset classes is therefore expected to improve the GPFG’s
risk-return trade-off.
Looking ahead, the GPFG will likely reduce its allocation to bonds from
today’s weight of 35 percent.
For a long-term investor, this is a sensible adjustment.
At the same time, it will signal that the authorities are willing to accept
considerable fluctuations in the return and size of the GPFG, at least on a
par with the volatility seen during the financial crisis.
Even though a number of countries hold substantial foreign exchange
reserves, Norway stands out.
In almost no other country does the central bank manage such a large and
diversified investment fund.
The GPFG has delivered solid results, and its management model has been
shown to be robust despite periods of rough weather.
Transparency, accountability and the safety of capital invested are
paramount.
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The organisation has been enlarged to manage a steadily growing and more
diversified portfolio.
Changes in the organisation of the GPFG may come.
But whatever the future solution may be, the primary objective of
investment management must remain firm: the highest possible return for
the benefit of current and future generations.
The GPFG should remain a financial investor.
If the government were to use the GPFG for other purposes, it would limit
the scope for achieving good returns and thereby Norway’s fiscal space.
Central banks in new and uncharted territory
Major shifts in export prices have not been alone in posing challenges to the
Norwegian economy through history.
Financial turbulence and banking crises created their own set of challenges.
Central banks play a particular role in the event of financial turbulence.
As the bankers’ bank, the central bank acts as lender of last resort.
The first time Norges Bank undertook this role was during the Christiania
Crash in 1899 – Norway’s first debt-driven real estate bubble.
When the most recent financial crisis hit Norway in 2008, our role as
lender of last resort was again put to the test.
Access to short-term funding dried up.
This also affected Norwegian banks.
Norges Bank had to provide liquidity support, and the government
implemented extraordinary measures to safeguard the financial system.
For Norway, the real economy effects of the financial crisis were
short-lived.
Other countries have had a more difficult time.
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Since the financial crisis, monetary policy in many countries has been
stretched close to the limit with the aim of putting economies back on their
feet and keeping inflation above zero.
Many countries are still experiencing weak growth.
This is not unusual in the wake of a financial crisis.
A post-crisis economic downturn may prove to be deep, and it may take a
long time to reverse the negative trend.
In a number of countries, little support from other policy areas has made
the job particularly demanding.
Never before in recent history have global interest rates been as low for as
long as they are today.
The interest rate level was moving down long before the 2008 financial
crisis.
What lies behind this is an enduring decline in long-term real interest rates.
The decline is attributable to structural changes that have weakened the
growth capacity of many economies, low productivity growth and weaker
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growth in the labour force.
In the wake of the financial crisis, interest rates fell from an already low
level to even lower levels.
Central banks slashed policy rates to counter the downturn.
The room for further rate cuts was gradually exhausted.
In this situation, central banks have shown a capacity for new thinking.
They have purchased securities on a large scale.
The purchases have continued to push down long-term rates.
In addition, a barrier has been broken.
In a number of countries, the policy rate is now negative.
Negative policy rates can affect the economy via lower bank lending rates
and a weaker exchange rate.
These are well-known channels.
But the effect of further policy rate cuts may weaken when rates fall below
zero.
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An important reason is that banks are reluctant to set negative deposit
rates, especially for households.
For many retail customers, substituting cash for bank deposits is fairly
inexpensive.
If banks hold back on deposit rates, lending rates can only fall to a limited
extent before banks’ earnings are reduced.
A lower policy rate may thus have less effect on lending rates than normal,
weakening the impact of monetary policy.
Over the past year, inflation among many of Norway’s trading partners has
approached zero.
For many years monetary policy was aimed at preventing high inflation,
while it must now seek to avoid inflation that is too low.
Central banks are in new territory.
A period of low inflation is not necessarily a problem as long as confidence
in the inflation target remains firm.
But when the room for further policy rate cuts is close to being exhausted,
steadily falling inflation could lead to a dangerous downward spiral.
For every notch that expected future inflation falls, real interest rates rise.
This has a contractionary effect on the economy.
In recent years, concerns about falling inflation expectations have
prompted central banks to cut policy rates further and to deploy
unconventional measures.
It has been argued that these monetary policy measures are necessary to
avoid a further fall in inflation as a result of a stronger exchange rate.
Interest rate cuts that lead to a currency depreciation push up inflation.
But countries cannot all weaken their currencies at the same time.
If many countries cut interest rates to boost inflation via a weaker currency,
the benefit may not materialise, while interest rates remain too low with
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respect to other considerations.
The financial crisis created unusually strong headwinds in the global
economy.
The persistent decline in long-term rates has been accompanied by a sharp
increase in debt levels in many countries.
Heavily indebted firms, households and government had to embark on an
extensive deleveraging process.
Weak growth prospects have restrained the willingness to invest.
Heightened uncertainty following the crisis may have reduced risk appetite.
The result is that the effect of policy rate cuts has diminished.
For the countries that took the lead, a loose monetary policy appears to
have worked.
In the US, the recovery has been on track for a while and unemployment
has declined.
Before Christmas, the Federal Reserve raised its policy rate for the first time
in nine years.
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In Europe, the recovery remains hesitant.
In emerging economies growth is slowing.
Since the beginning of the year, global financial markets have been marked
by considerable turbulence, likely owing to increased uncertainty about
global economic prospects.
The period of low interest rates is likely far from over.
The headwinds from the financial crisis are still being felt by many large
economies.
With both interest rates and inflation close to zero, room for manoeuvre in
monetary policy is limited.
Central banks will have little left in their arsenal in the face of a new
downturn.
Other policy areas will then have to take on a greater role.
A solid financial system over time
An environment of persistently low interest rates may pose challenges to
financial stability.
Low interest rates are still driving up debt levels, making economies
vulnerable to shocks.
Just as monetary policy represents the first line of defence in managing the
business cycle, regulation and supervision of financial institutions must be
the first line of defence in maintaining financial stability.
It is not sufficient for individual banks to be solid.
Banks are closely interlinked.
They obtain funding from common sources and from one another, and
large portions of loan exposures are in the same markets.
High credit growth can result in financial imbalances that have
system-wide effects.
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System-wide risk is therefore far greater than the risk of individual banks.
The financial crisis showed the severe damage that can be caused when
insufficient attention is paid to system-wide financial risk.
Banking regulation has therefore been strengthened by including a
macroprudential component.
The instruments employed are not new, but an important difference is that
banks are required to hold more equity capital than previously.
The required level is based on the overall risks to the financial system.
Some requirements may vary over time, such as the countercyclical capital
buffer.
The regulation of the Norwegian financial sector is in line with
international standards.
In recent years, a number of instruments have been implemented in
Norway to mitigate risk in the banking system.
In response to the sharp rise in real estate prices and household debt, the
countercyclical capital buffer has been increased and bank lending
standards tightened.
Moreover, capital surcharges have been introduced for systemically
important banks.
Norwegian banks have made good use of the solid earnings and low loan
losses of recent years.
Banks have built up their capital and adapted to new buffer requirements.
The buffers can be used in the event of a pronounced economic downturn.
Banks will then be able to absorb loan losses without a significant reduction
in new lending.
The build-up of financial imbalances can be difficult to identify.
Financial crises can occur suddenly and unexpectedly.
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When they do occur, the banking system must be solid.
Most regulatory components should be as stable as possible.
The aim of macroprudential supervision cannot be to fine-tune the
economy over the business cycle.
But when financial turbulence occurs, the authorities must be prepared to
act quickly and in concert.
In Norway, the Ministry of Finance has the overriding responsibility for
macroprudential supervision.
It is natural that the political authorities make decisions regarding the
framework and permanent regulations.
It would be an advantage to delegate the responsibility for time- varying
instruments to an independent authority with a view to ensuring effective
implementation and predictability over time.
Conclusion
After two decades that can be described as a golden age, the Norwegian
economy is heading for a demanding period.
We have always known that the long oil-driven expansion would come to an
end, either because the activity level would pass the peak, or because oil
prices would fall.
We have now reached that juncture.
The challenges are twofold.
One challenge consists of further developing the technology and expertise
gained in oil production and oil services.
Costs have been brought down at many stages to strengthen
competitiveness in response to lower oil prices.
If we succeed in this endeavour, the oil industry will continue to be a pillar
of the Norwegian economy for many decades ahead.
The other challenge lies in paving the way for growth in other industries
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and replacing the revenue shortfall and jobs shed in the oil industry owing
to lower activity levels.
The groundwork is in place.
In recent years, the Norwegian financial system has been strengthened.
During a period of restructuring, it is crucial that banks are in a position to
channel credit to projects and businesses that will generate new growth.
We have more fiscal policy muscle than most countries, but it must be used
sensibly.
The social partners seem to understand the gravity of the situation and are
prepared to do their share.
Monetary policy can be geared to facilitate the necessary structural
changes.
Norges Bank is in its 200th year.
As a central bank, we have a responsibility to promote economic stability.
In addition, the Bank is responsible for managing Norway’s collective
financial wealth.
The responsibility we have been given cannot be taken for granted.
It is a mission that must be merited.
Under the parity policy of the 1920s, the economic downturn was amplified
by the desire to return to parity.
In hindsight, that policy was described as one- eyed.
If today’s inflation targeting regime is to avoid the same label, it must be
practiced flexibly so that it fosters economic stability over time.
Confidence in low and stable inflation remains firm.
That must always be the main task of monetary policy.
Yet our own history and the recent experience of other central banks have
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shown that the system can come under pressure.
When circumstances change, central banks must also be capable of
adapting and new thinking.
We must learn from the past, be prepared for sudden shifts and seek out
new solutions.
Come what may.
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Interest rate benchmarks
Guy Debelle, Assistant Governor (Financial Markets) of
the Reserve Bank of Australia, at the KangaNews Debt
Capital Markets Summit 2016, Sydney
I would like to thank Ellis Connolly for assistance in the preparation of
these remarks.
Today I am going to talk again about interest rate benchmarks, as there
have been some important recent developments.
These benchmarks are very much at the heart of the plumbing of the
financial system.
They are widely referenced in financial contracts.
For example, the interest rate on a corporate loan is often a spread to an
interest rate benchmark.
Many classes of derivative contracts generally are based on them, as are
most asset-backed securities.
In light of the issues around London Inter-Bank Offered Rate (LIBOR) and
other interest rate benchmarks, there has been a global reform effort under
the aegis of the Financial Stability Board (FSB) and the International
Organization of Securities Commissions (IOSCO) to improve the
functioning of interest rate benchmarks.
I will focus on domestic reforms around the principal interest rate
benchmark in Australia, the bank bill swap rate (BBSW).
I will also mention plans underway to introduce a “risk-free” interest rate
for the domestic market, as a complement to BBSW.
I will not talk about the investigations that ASIC is currently undertaking
into conduct around BBSW.
Reforms to the BBSW methodology
As you may be aware, in recent months, the Council of Financial Regulators
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(CFR) has been conducting a consultation on possible reforms to the BBSW
methodology.
I will run through the motivation for doing so, outline the key issues that
have been raised in the consultation, and put forward some proposed
reforms for market participants to consider.
Given its wide usage, BBSW has been identified by ASIC as a financial
benchmark of systemic importance in our market.
It is important there is ongoing confidence in it. Without that, we have a
serious problem, given its integral role in the infrastructure of domestic
financial markets.
As you may know, BBSW was calculated for a number of years by, each day,
asking a panel of banks to submit their assessment of where the market was
trading in Prime Bank paper at a particular time of the day.
While it was a calculation based on submissions, it differed from LIBOR in
that BBSW submitters were asked about where the market for generic
Prime Bank paper was trading that day.
In contrast, LIBOR submitters were asked about where they thought their
own bank’s cost of funds was that day.
In response to the prospect of a large number of the participants on the
submission panel no longer being willing to provide submissions, the
calculation of BBSW was reformed in 2013 in line with the IOSCO
Principles for Financial Benchmarks, which were issued in July 2013.
Since 2013, the Australian Financial Markets Association (AFMA) has
calculated BBSW benchmark rates as the midpoint of the (nationally)
observed best bid and best offer (NBBO) for Prime Bank Eligible Securities,
which are bank accepted bills and negotiable certificates of deposit (NCDs).
Currently, the Prime Banks are the four major Australian banks.
The rate set process uses live and executable bid and offer prices sourced
from interbank trading platforms approved by AFMA, These platforms are
currently ICAP, Tullett Prebon and Yieldbroker.
The bids and offers are sourced at three points in time around 10.00 am
each day.
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While the outstanding stock of bills and NCDs issued by the Prime Banks
has increased since 2013 to around $140 billion (Graph 1), trading activity
during the daily BBSW rate set has declined over recent years to very low
levels (Graphs 2 and 3).
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There are quite a number of days where there is no turnover at all at the
rate set. The low turnover in the interbank market raises the risk that
market participants may at some point be less willing to use BBSW as a
benchmark.
This is the motivation for the CFR’s consultation to ensure that BBSW
remains a trusted, reliable and robust financial benchmark.
There is considerably more activity in the NCD market than is being
measured at the rate set, with the activity mainly occurring outside the
interbank market.
Given the size of the market and the short maturity of the securities, on
average over $1 billion in NCDs are issued each day.
Some preliminary data collected from the four major Australian banks
indicate that this issuance is regular, with at least $100 million in NCDs
bought or sold on almost all business days at the one, three and six-month
tenors.
However, the non-bank participants that buy and sell NCDs tend to
transact bilaterally with the issuing bank, with the price struck at the (yet to
be determined) BBSW rate, rather than at a directly negotiated rate.
If these participants could be encouraged to buy and sell NCDs at outright
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yields, then these transactions would have the potential to make the BBSW
benchmark more robust.
Consistent with there being a shift in NCD trading activity to outside the
interbank market, banks’ holdings of NCDs as a share of total issuance has
declined over recent years to below 20 per cent (Graph 4).
Over the same period, there has been a steady increase in holdings by super
and other investment funds, with their share of NCD issuance rising to
almost half recently.
As part of the consultation, the CFR received 15 written submissions from a
wide range of market participants, including the Prime Banks, NCD
investors, and users of BBSW as a benchmark.
We have also spoken directly with market participants to better understand
what has caused the decline in trading activity during the rate set and to
discuss potential solutions.
To bring all this together, the CFR recently released a discussion paper for
AFMA and market participants to consider, which summarises the views of
market participants and proposes some improvements to the BBSW
methodology.
Most market participants share our concern about the low trading volumes
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during the rate set and acknowledge that changes to the BBSW
methodology will be necessary.
But before making any changes, it is crucial to understand why so little
trading has been occurring during the rate set.
Four key reasons were put forward by market participants:
• First, institutions face a potential conflict of interest when they participate
in the market underpinning a benchmark as well as the derivatives market
that references the benchmark.
Many institutions state they are uncertain about how regulators expect
these conflicts to be managed.
As a result, they are reluctant to trade during the rate set.
• Second, managers of money market funds are reluctant to trade at
outright yields during the rate set.
They prefer to agree the volume of their bill transactions with a Prime Bank
before 10.00 am and set the rate after 10.00 am at BBSW, since this
minimises their tracking error against their benchmark.
• Third, investors subject to credit limits are reluctant to trade during the
rate set where bills are traded as a homogeneous asset class, as they could
be delivered the bills of a Prime Bank for which they have already used up
their credit limit.
• Finally, foreign bank branches have less demand for bank paper than in
the past since it is not considered a high-quality liquid asset under the
Liquidity Coverage Ratio either in Australia or in their home jurisdictions.
Despite these challenges, it is crucial that BBSW remain a trusted, reliable
and robust financial benchmark given its importance to the financial
system.
To ensure this, the CFR has put together a proposal for the evolution of the
BBSW methodology, taking into account the feedback provided through the
consultation process.
In putting forward this proposal, the key objectives are to ensure that:
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• BBSW is anchored to observable arm’s length transactions in an active
underlying market;
• the BBSW calculation mechanism is robust to changing market
conditions;
• the fundamental properties of BBSW are maintained to ensure a seamless
transition for financial contracts as the methodology evolves.
While most participants are in favour of some changes to the methodology,
there are many features of the existing methodology where there is
consensus that they should be retained.
In particular, there was broad support that the securities underlying BBSW
continue to be the NCDs and bank bills of the Prime Banks, as they are
relatively homogeneous and liquid.
As a result, we don’t need to go down the path of calculating BBSW as a
broader measure of banks’ short-term wholesale funding, as is being
considered for LIBOR and Euro Interbank Offered Rate (EURIBOR).
This avoids the risk of there being a significant change in the characteristics
of BBSW which could lead to contract frustration.
To boost activity during the rate set, most submissions supported
broadening the definition of the underlying market beyond the interbank
market to include transactions with a wider range of counterparties, such as
investment funds and the treasury corporations.
These submissions highlighted that there is much more activity in the
market prior to the rate set than during the rate set.
This activity prior to the rate set has the potential to underpin BBSW,
assuming market participants agree to transact at directly negotiated rates
rather than at BBSW.
Given the much larger role that non-banks play in the market, we agree that
it is time to widen the underlying market beyond the interbank market to
include such counterparties.
There is a risk that activity in the interbank market alone will not be
sufficient to support the calculation of BBSW, and the credibility of the
benchmark would be enhanced by the participation of counterparties that
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come from outside the banking sector.
The key change to the methodology proposed by many of these submissions
was to calculate BBSW directly from market transactions, rather than using
the NBBO method.
That is, calculating BBSW as the volume-weighted average price (VWAP) of
market transactions during the rate set window.
Given the objective is to better anchor BBSW to transactions in the
underlying market, we support moving the calculation methodology to the
VWAP.
Calculating the VWAP should be feasible for the one, three and six-month
BBSW tenors, since these are the most liquid.
The Prime Banks issue three and six-month NCDs on almost a daily basis,
and there is an active market in buying back one month NCDs.
If there were to be insufficient transactions to calculate the VWAP at these
tenors, NBBO was widely supported by market participants as an
appropriate fall-back methodology.
However, there is unlikely to be sufficient liquidity in the underlying
market at the two, four and five-month tenors to reliably calculate the
VWAP, so we propose that these tenors be calculated by interpolation from
the more liquid tenors.
While there was solid support for the VWAP methodology, there was a wide
range of views as to how the transactions during the rate set should be
executed.
Three methods proposed were:
1. Direct negotiation between Prime Banks and investors, with issuance and
secondary market transactions being negotiated and executed in terms of
outright yields, most likely over the phone.
A rate set window of around 60–90 minutes (for instance, from 8.30 am to
10.00 am) should provide sufficient time for such transactions to take
place.
2. An electronic trading market, with transactions being executed on the
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trading platforms where the Prime Banks and investors post bids and offers
in terms of outright yields for a particular Prime Bank’s NCDs.
A rate set window of around 30–45 minutes (for instance, from 9.15 am to
10.00 am) should be sufficient.
3. A tender process, with the issuance and secondary trading of each Prime
Bank’s NCDs taking place in terms of outright yields through an auction.
Given that all the transactions would be executed at the same time, the rate
set window could be quite short (for instance, bids and offers could be
submitted over a 15-minute period, with the tender closing at 10.00 am).
Each of these methods has its advantages and disadvantages.
Conducting the transactions over the phone is flexible and is most similar
to current market practice, so it would be unlikely to require extensive
changes to systems and procedures.
However, it would be the least transparent, which may discourage
participation from investors and necessitate more oversight of the conduct
of market participants.
An electronic trading market would also be able to facilitate a wide range of
transactions while significantly improving market transparency.
However, the platforms currently only serve the inter-bank market, so
other participants would need to change their systems and procedures.
Finally, a tender would probably have the shortest rate set window,
reducing basis risk for investors and minimising the length of time that the
Prime Banks are required to make prices.
However, the design of the tender would be quite complex to support a wide
range of transactions such as switch trades (where, for instance, an investor
simultaneously sells NCDs with a one-month tenor and purchases those
with a six-month tenor).
This may lead some market participants to be reluctant to participate.
While none of these execution methods is clearly superior to the others in
all dimensions, the market will need to eventually coalesce around one of
them to maximise the amount of activity during the rate set.
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To me, the methods involving trading on electronic platforms are the most
attractive, given the associated visibility and transparency that comes with
trading across a platform.
However, to ensure that BBSW remains robust in the near term, it may be
necessary for market participants to continue transacting over the phone
but at outright yields, and for the benchmark administrator to use these
transactions to calculate the VWAP.
Regardless of which method for executing the transactions is chosen, the
key challenge is going to be to get investors to be more comfortable with
transacting a significant share of their NCD transactions at directly
negotiated rates.
Maintaining BBSW as a robust benchmark is clearly in everyone’s best
interest, including the Prime Banks, since many of their loan contracts
reference BBSW, and the investment funds, since BBSW is their
performance benchmark.
So to some extent, we should be able to rely on the survival instincts of all
participants in the market to encourage more activity during the rate set.
This is why we are proposing that the market convention should be for the
Prime Banks to conduct their primary issuance and secondary market
trading in terms of outright yields during the rate set window.
Nevertheless, the current lack of trading activity during the rate set suggests
that there may need to be more explicit incentives to encourage
participation in the rate set, particularly from a broader range of NCD
investors.
Assuming the market shifts to trading on the electronic platforms, the
improvement in market transparency that would result may be enough to
encourage more buy-side participation.
We note that some submissions suggested more onerous alternatives.
For instance, one way to ‘encourage’ investors to transact at outright yields
would be for the Prime Banks to charge a fee for Eligible Securities
transactions negotiated at the BBSW rate.
Alternatively, if the bulk of market activity continues to take place outside
the rate set window, the Administrator could keep widening the window,
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which at the extreme could be a 24-hour period to ensure that all market
activity is within scope.
We do not support these alternatives at this stage, as they would not be in
the best interests of investors.
However, if activity during the rate set continues to be too low to sustain
BBSW in the medium term, then these alternatives may need to be
reconsidered.
So the key questions that we are left with are:
• First, how should the transactions be executed during the rate set window
for BBSW to be calculated as the VWAP?
• Second, will market participants be willing to transact at directly
negotiated rates rather than at BBSW?
These questions are the focus of our continuing discussions with AFMA and
market participants.
While the CFR has an ongoing interest in BBSW as a systemically important
financial benchmark, the ultimate responsibility for the BBSW
methodology, and the implementation of any changes, resides with the
administrator of the benchmark.
The CFR appreciates that AFMA and market participants will need to give
the proposal in the discussion paper further consideration, and that any
associated changes to market practice and infrastructure will take time to
implement.
As a result, it will be necessary for the current BBSW methodology to be
maintained for a period.
To support this process, we have put forward a timeline for consideration of
the proposal by AFMA and market participants as well as the
implementation of changes by the administrator.
We would like to see AFMA complete any further consultation and finalise a
set of amendments to the BBSW methodology by the middle of this year,
and for the changes to be implemented by the end of this year – although
we acknowledge that the feasibility of this timeline will depend on the scope
of the amendments to the methodology that are eventually implemented.
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Risk-free rates
Next I would like to briefly raise some issues around whether the use of
BBSW needs to be quite as widespread as it is.
In a number of instances, BBSW has become the default reference rate
without much thought being given as to whether it is the most appropriate
reference rate.
BBSW is a credit-based reference rate.
It is based on the borrowing costs of the major banks, with the credit risk
that entails embodied in the rate.
For a number of purposes, a credit-based rate is completely appropriate.
However, for other purposes, a rate that is closer to risk-free may be more
appropriate.
For instance, in recent years, market participants have moved to use
overnight-indexed swap (OIS) rates more often when discounting the cash
flows in their swaps.
The FSB, through its official sector steering group (OSSG) on benchmark
reform, is encouraging market participants to contemplate switching from
credit-based benchmark rates like BBSW or LIBOR to risk-free rates, where
appropriate.
In the local market, there appears to be growing interest in using risk-free
rates as benchmarks.
Such a rate could be backward looking, like the cash rate, or forward
looking, like OIS rates.
As a first step, some market participants have indicated that a total return
index of the cash rate would be a useful backward-looking benchmark.
Implementing this would be straightforward, since the RBA already
calculates and publishes the cash rate.
Some market participants are also interested in referencing a
forward-looking rate with equivalent tenors to BBSW, and we will continue
to work with AFMA on the development of such a benchmark.
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One example where a change in reference rate could be contemplated is for
floating rate notes (FRNs) issued by governments.
FRN coupon payments are typically priced at a spread to BBSW.
While referencing BBSW makes sense for FRNs issued by banks, it is less
clear why governments should tie their coupon payments to a measure of
bank funding costs.
That is one example worthy of consideration.
There are a number of others.
I know this is not necessarily an issue you may have thought that much
about until now.
At the very least, I would encourage you to at least ask the question whether
the product you are issuing or holding is using the most appropriate
reference rate.
Conclusion
Let me conclude. Interest rate benchmarks such as BBSW are a very critical
part of the plumbing of the financial system.
Market participants need to have confidence in their robustness and
integrity.
To help ensure that is the case, the CFR has undertaken a consultation
process on the BBSW methodology.
The industry, working through AFMA and with the CFR, will need to act on
these proposals to ensure that BBSW remains a trusted, reliable and robust
financial benchmark.
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Philippines in 2016 - sustaining resilience
amid headwinds
Amando M Tetangco, Jr, Governor of Bangko Sentral
ng Pilipinas (BSP, the central bank of the
Philippines), at the 3rd Business Forum of The
Manila Times, Manila
I am pleased to join you this morning for the 3rd Manila Times Business
Forum.
There are quite a number of fora that tackle economic outlook and issues of
the day, but I don't know of any that is organized by a private institution,
which dates itself to the time the country became independent from Spain!
In addition, The Manila Times President & CEO Mr. Dante Ang said earlier
that this forum gathers various speakers, including those officials from
institutions such as IMF, WB and BSP to present their prognosis for the
economy this year.
Very few institutions stand the test of time - technology, innovation, and
more recently, social media, among others; change the way we do things,
how we perceive events, and therefore how we react.
Central banking in the Philippines is just 67 years old and yet the events of
the last two decades have dramatically changed how we do things.
I am sure many, if not all of you, have heard of central banks lowering their
policy rates to negative territory, of quantitative easing (QE), and of
macroprudential measures.
In reality, the central banker's tool box now contains other implements
beyond the traditional interest rate and on-site supervision.
But, I am getting ahead of myself here.
I've been asked to speak on the Philippine economic outlook for 2016.
While that seems much focused, our conversation today will certainly touch
upon global events of the last few years and our expectations beyond 2016.
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For me to speak of 2016 however, I need to take a step back.
A newspaper lives or draws interest from its public through its headlines.
And since this Forum today is being hosted by The Manila Times, I thought
I would frame my talk today as a series of headlines.
My first is this - The Philippines entered 2016 from a position of relative
strength.
The country grew 5.8 percent for the full year 2015.
If we take Q4 alone, the country grew at 6.3 percent, making us the 4th
fastest growing economy in Asia, following India, China and Vietnam.
That Q4 performance also brings to 68 the number of consecutive quarters
of positive economic growth.
The services sector remained the biggest driver of output while the
resurgence of manufacturing also helped to strengthen our base for growth.
Growth also continued to be buoyed by strong private spending, aided by
the increase in domestic employment and the steady inflow of remittances
from overseas Filipinos (OFs).
The "catch up" in fiscal spending in 2015 also helped to raise domestic
output.
We experienced this strong economic growth together with low and stable
prices.
For the full year 2015, the average inflation rate stood at only 1.4 percent,
the lowest registered since the BSP adopted the inflation targeting
framework in 2002.
In the BSP, we characterize this "sweet spot" as - the positive convergence
of strong growth and low inflation.
For certain, the country's healthy banking system founded on years of
judicious reforms, including financial inclusion initiatives, aided the
country's economic expansion.
Our banks' balance sheets have remained strong.
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In particular, our banks maintain high capital, with capital adequacy ratio
above national regulatory and international standards and the quality of
their assets continues to improve, with declining NPL and NPA ratios.
The country's external liquidity position has also continued to be robust
and helped shield the economy and the domestic financial markets from the
worst effects of the global shocks.
Our current account has been in surplus since 2003 supported by steady
remittances and, in more recent years, strong receipts from the business
process outsourcing sector.
For the full year 2015, the overall balance of payments (BOP) position
yielded a surplus of US$2.6 billion, a reversal from the US$2.9 billion
deficit in 2014.
Last Friday, we released the balance of payments position for January 2016.
It was a deficit of $0.81 billion, which was due to the payment of National
Government (NG) debt service and the BSP's foreign exchange (FX)
operations that were only partially offset by FX inflows from deposits of the
NG and BSP income from abroad.
We see this deficit as temporary and we expect a turnaround in the BOP
position later this year, similar to what we experienced in 2015.
Our gross international reserves continue to grow.
At end 2015, our gross international reserves (GIR) stood at US$80.7
billion, over US$1.0 billion more than that registered in 2014.
This level of reserves can cover 10.3 months' worth of imports of goods and
payment for services and income.
These encouraging developments have helped elevate third-party
assessments on the domestic economy's progress and prospects.
Several indices of the country have moved up.
These indices include those on transparency, governance and ease of doing
business, among others.
In September last year, Fitch upgraded its credit outlook on the Philippine
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economy to "positive" from "stable."
This is important because it raises the prospect that Fitch would upgrade
the country's credit rating in the next 12-18 months.
Ladies and gentlemen, the facts and figures that I just discussed provide
evidence to support the first headline, that is, that the Philippines entered
2016 from a position of relative strength.
My second headline: The Philippines is SEEN to SUSTAIN resilience in
2016.
Resilience is a word that many use, but it is important to remember that
this is a word that holds meaning only when it is taken in context.
In other words, in a specific circumstance.
Clearly, resilience cannot be tested if one is sailing over calm seas.
For us, 2015 was not at all calm.
It was a challenging year.
The markets and other policy makers were cautious.
We were all waiting for the Fed "lift off" (or when the Fed would begin to
raise its target rate).
We weren't sure where oil prices were headed.
We didn't know how to fully interpret the actions by Chinese authorities,
including the devaluation of the Renminbi (RMB).
And yet, in the face of all these uncertainties, the country stood its ground
in 2015.
2016 was off to a bumpy start.
While, we foresee the same risk factors in 2016 as those in 2015, it may be
more difficult to predict how these factors would play out in 2016.
Policy makers are being more sensitive to spill overs and spillbacks to their
economies.
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And market sentiment continues to be "shifty."
Let me quickly go through how we see each challenge evolving in 2016.
Let me begin with China.
When the global financial crisis (GFC) started in 2007/2008, global growth
remained afloat because the emerging markets, the largest of which is
China, were growing.
This time around, China's growth prospects are not as clear-cut as then.
There is now debate whether China could experience a hard landing.
This is creating market uncertainty, because in addition to contraction in
global trade, a significant slowdown in China could also put downward
pressure on global commodity prices.
Furthermore, the markets are carefully watching the Chinese authorities'
next moves to liberalize their markets.
You may recall the stock market rout in China in August last year.
That was precipitated by the surprise RMB devaluation.
That led to a sell-off in equities across the globe.
Analysts say that to avoid a recurrence of such adverse reactions, markets
need to see more cohesiveness in the policy measures from Chinese
authorities, as well as clarity in their communication.
In the US, the Fed, in December 2015, determined that the US labor market
conditions and inflation outlook already warranted "lift off".
Based on the assessment of the FOMC members then, the Fed was
projected to raise its target rate by 100 basis points in 2016.
But more recent statements of some Fed governors now reveal less
conviction in terms of the speed and magnitude of normalization of its
policy.
Even Fed Chair Yellen indicated in her latest testimony to the US Congress
that foreign economic developments could pose "risks to economic growth."
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Some analysts have taken these recent statements to mean that the Fed may
delay its next tightening moves.
This uncertainty is heightening market volatility - yet again!
Turning to oil - oil price is now at about $30 per barrel (pbl). In mid-2014,
it was about $108 pbl.
While the rate of decline has decelerated, the price is now at levels that have
triggered major oil producers to "come to the table" to discuss the
possibility of "freezing" production to specific output levels.
Global oil supply has overtaken demand since 2014.
Oil importers such as the Philippines benefit from low oil prices.
Low oil prices feed positively towards lower inflation and encourages
domestic economic activity.
But low prices are double-edged in that significantly low oil prices could
lead to oil-exporters cutting back on capital expenditures.
This in turn may trigger a decline in global trade and growth.
The uneven global growth prospects, the differences in the policy actions
across the globe, and the uncertainty in oil price movements are triggering
global portfolio rebalancing.
As market players flesh out their interpretation of these developments,
volatility in financial markets is heightened.
According to the Institute of International Finance (IIF), emerging market
economies (EMEs) experienced strong net capital outflows in 2015.
It forecasts that further net outflows from China are expected to continue in
2016.
These net movements of funds from EMEs in 2015 have been reflected,
among others, in a decline in ASEAN stock market values and an increase
in the volatility of currencies in the region.
How could these developments impact the Philippines?
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I already spoke earlier about the positive impact of low oil prices on the
Philippines - which it helps reduce inflationary pressures while encouraging
domestic consumption.
We could, however, be adversely affected if the low oil prices cause export
destinations of our OFWs in the Middle East to cut back on employment.
As for the divergent growth prospects in the US and China, we could be
affected via the trade channel.
If US growth will continue and gain further traction, this could mitigate the
impact of a slowdown in China.
Furthermore, our domestic financial markets have not been spared from
the market volatility that these external developments have stirred.
The Philippine Stock Exchange index (PSEi) fell, credit default swaps (CDS)
and bond spreads widened, and the peso depreciated.
To complete the picture, I should mention that we have our own domestic
considerations in addition to these external challenges.
Most prominent of our domestic risks are the prospects of a prolonged El
Niño and the persistence of the infrastructure gaps.
Ladies and gentlemen, this is the operating environment expected in 2016.
As I said, while it's the same factors, how these factors will play out may not
necessarily be the same in 2016.
To paraphrase the title of the book of Reinhart and Rogoff, "This time it
COULD BE different."
You may ask - How can we claim (as a second headline) that - "the
Philippines will sustain its resilience in 2016?"
First, because we have come into 2016 from a position of relative strength.
This was my first headline.
Second, from the point of view of the BSP, we have been focused in our
policy thrusts.
We are forward-looking in our policy formulation.
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Let me illustrate using our monetary policy.
In 2014, we moved pre-emptively, in anticipation of the Fed lift off. Markets
had been talking about "lift off" since the Fed "taper tantrum" in May 2013.
But because until 2014, the Fed had only moved to end QE and not actually
raise rates, markets kept on "pushing the envelope," so to speak, in terms of
maximizing the benefits of low interest rates.
Through a series of tightening measures, we communicated to the market
then that players should begin to take stock of how they were assessing and
pricing risk.
In a way, the BSP was reminding banks (and the general public) that
interest rates would not remain low forever, and that there is need to
re-think business models and investment strategies.
We also ensured that our tightening measures were consistent with the
inflation outlook at the time.
Because our actions were early enough, our markets were well-positioned
when the Fed finally raised its target rate in December 2015.
We are not only forward-looking; we are also calibrated in our actions and
mindful of the idiosyncrasies of our domestic economy.
Let me illustrate using our approach to banking reform.
In the aftermath of the GFC, the global financial market reform agenda was
thick and heavy-handed, primarily because there was much fear of a
recurrence of crisis from slack regulation.
The Philippine banking system was not as affected by the GFC.
In part, because our bankers are inherently conservative.
Therefore the BSP adopted the global reforms in a calibrated manner and
only as appropriate to our domestic conditions.
We were an early adopter of the capital requirements under Basel 3, and we
are now phasing in the rest of the components of Basel 3.
In addition to adopting global reforms that are suited to our particular
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requirements in a timely manner, we also put out regulations and
guidelines that are intended to raise bank governance standards,
strengthen credit, operational, IT risk management and internal control
frameworks, and improve market conduct.
Our approach to regulatory reform is anchored on Financial Stability.
This is an important lesson we learned from the GFC.
Most policy makers have now come to realize that having strong individual
banks, while that is necessary, is NOT sufficient.
Policy makers need to consider the strength and soundness of the system as
a whole.
Our regulations benefit from consultation with the banking industry and
are evidence-based.
We meet with industry associations and groups - 15 in all - through the BSP
Supervisory Policy Committee.
Putting all these together, you can see that our approach to regulatory
reform and adoption is comprehensive and strategic.
Our goal is not only to grow strong domestic banks but also banks that can
compete in the global arena, particularly when ASEAN integration comes to
full swing.
BSP policy formulation is forward-looking.
It is calibrated and consultative.
It is also based on solid academic foundations and strong market
surveillance.
In policy formulation, the BSP uses various econometric and macromodels.
To help ensure that these tools are current against the latest economic
research, we constantly fine tune our forecasting models, stress-tests
parameters; recalibrate early-warning systems and distress indices.
You may have also heard about our implementation of the interest rate
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corridor (IRC) in Q2 2016.
As we've emphasized in our public briefings, the implementation of the IRC
is an operational change.
It is not a shift in our monetary policy framework. We will continue to be an
inflation targeting central bank.
The objective of the operational shift is to allow BSP to better steer
short-term market interest rates towards the BSP policy rate.
This should make the transmission of changes in the monetary policy
stance to the rest of the economy more effective.
Ladies and gentlemen, while we are improving how we do things, there will
be no change in our primary mandate - we will keep our eye on inflation.
At our most recent policy meeting, we kept policy rates steady (at 4 percent
for the reverse repurchase rate).
Our view was that domestic demand continues to be quite robust and there
is no urgent need to provide further monetary stimulus.
Our models showed that even as inflation is currently below our target
range of 2-4 percent (i.e., 1.3 percent in January 2016), inflation will slowly
move to within target in 2016 (i.e., 2.2 percent) and 2017 (i.e., 3.2 percent).
Going forward, we will continue to closely monitor the inflation process.
We will also keep our FX policy of allowing the exchange rate to be
determined by market forces.
We are mindful that the peso is sensitive to external developments, so we
will have scope for official action to limit excesses in exchange rate
movements.
Ladies and gentlemen, let me reiterate, we have the policy space to respond
to uncertainties in the external and domestic environment.
We will therefore make adjustments to the stance of policy as conditions
warrant.
Headline number 3: A stable macroeconomy should be inclusive.
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Some of you in the audience may be wondering why the Central Bank
Governor would speak about inclusiveness.
With the many macroeconomic and banking concerns it already has, should
the central bank still be involved in inclusion.
Our response in the BSP is YES, we should.
We cannot ignore the financial consumer.
When all is said and done, the purpose of a stable macroeconomic
environment is ultimately to improve the consumer's well-being.
In the BSP, we have institutionalized financial inclusion in our strategic
agenda.
We put in place banking regulations that leverage on technology to increase
access to financial products for the underserved and unbanked, strengthen
financial consumer protection, and raise financial education and awareness
to these new financial products and modes of delivery.
We will also pursue the development of our National Retail Payments
System or NRPS.
The NRPS should move the country from being cash-heavy to being
"cash-lite".
The NRPS is expected to improve transparency, security, and efficiency and
reduce costs in financial transactions.
Ladies and gentlemen, I presented three headlines.
First, the Philippines bucked the trend in 2015.
Next, we will continue to be resilient in 2016.
And, finally we will endeavor to share the fruits of a strong macroeconomy
to a broader cross-section of the economy.
These three should be sufficient to make a full page of news.
Indeed, our country has continued to expand despite the difficult external
and domestic operating environment.
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It has been said that difficulty or adversity BUILDS character.
In a way, we can say that the challenges our country has faced so far, and
continue to face, have helped BUILD our character.
We have also built buffers in the interim.
And have become stronger as a nation.
But, I also believe difficulties or adversities REVEAL character.
The challenges and difficulties we have faced have revealed that we, as a
nation, have what it takes to be resilient.
However, ladies and gentlemen, these sources of resilience and buffers, the
gains that we have attained so far, all these can only be fully harnessed if
YOU in the private sector will continue to do your part as well. YOU turn
the wheels of industry and business.
YOUR actions will help solidify these gains.
I hope to see YOU make headlines of your own.
Headlines that will help ensure the Philippines sustains resilience in 2016
and beyond.
Thank you.
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