Introduction to the Annual Report of the Commission Bancaire by cnolynne

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									      Introduction to the 2006 Annual Report
      of the Commission Bancaire:
      Overview of the French banking system

      FRENCH CREDIT INSTITUTIONS
1     REPORTED HIGH EARNINGS AS
      GLOBAL ECONOMIC CONDITIONS
      REMAINED POSITIVE

1.1. Favourable business conditions despite
     periods of volatility on financial markets

    Sustained world economic growth with
    a new geographical balance

   French credit institutions once again reaped the benefits of a
favourable economic environment in 2006. International expansion,            World growth
rather than domestic business, underpinned the business volumes of            1998 - 2006
major international banking groups. In April 2007, the International    6%


Monetary Fund estimated that world economic growth was still            5%


strong, at 5.4% in 2006, as opposed to 4.9% in 2005. It was also more   4%

                                                                        3%
uniform, with slower growth in the USA and faster expansion in the
                                                                        2%
euro area, where growth was at its highest level since 2001. This was   1%

also the case in Japan, especially at the end of the year. The non-     0%

OECD economies, including emerging economies in Asia and Central               Source: IMF

Europe, continued to play a major role in world growth, as strong
exports and high commodity prices benefited producer countries.

   In the euro area, GDP grew 2.6%, nearly twice the rate posted in
2005. France’s performance in this favourable environment was
moderate, with 2.1% growth in 2006, according to INSEE, France's
national statistics institute, following 1.2% in 2005. Household
consumption expenditure made the main contribution to 2006 GDP
growth, as was the case in 2005. Investment continued to recover,
for the third year in a row, with an annual growth rate of 4.6%. Both
these factors fuelled growth in lending by financial institutions to
the private sector.




                                                                                             7
                                                                            Large companies in the euro area increased their debt, as risk-
            Global corporate default                                     related costs were very low and the corporate default rate conti-
                   1999 - 2006                                           nued to decline. Spreads between corporate and government
225                                                               4%     bonds – the risk premium paid by low and medium-rated issuers –
200                                                              3,5 %
                                                                         was practically stable year on year. Risk premiums were at historic
175
                                                                  3%
150
                                                                 2,5 %
                                                                         lows, for example 70 basis points for BBB-rated corporate borro-
125
                                                                  2%     wers, below the 120-bp peaks of second-quarter 2005 and conside-
100

 75
                                                                 1,5 %   rably less than the average spread of more than 200 basis points
                                                                         reached in the early part of this decade. Low risk premiums reflect
                                                                  1%
 50

 25                                                              0,5 %

  0                                                               0%     ample liquidity in the markets, which forces yield-seeking investors
      Total debt defaulting (GUSD)           Default rates (%)           to take greater risks.
                      Source: Standard & Poor’s


                                                                            Dynamic financial markets,
                                                                            with occasional periods of volatility

                                                                             Against this favourable macroeconomic backdrop, financial
                                                                         markets rose sharply, as companies posted strong earnings and
                                                                         liquidity levels remained high. These developments enabled the
                                                                         markets to cope with higher volatility in the second quarter of 2006.
                                                                         Institutional investors’ determination to diversify their asset portfo-
                                                                         lios explained much of the international flow of investment. The
                                                                         quest for higher yields stimulated international bond issuance,
         Stock markets in 2006                                           which was also boosted by the overall improvement in average
      December 2005 average = 100                                        credit risk on the sovereign debt market.
125
120
115
                                                                            Stock markets advanced strongly in 2006. After a four-year bull
110
105
                                                                         run, France’s CAC 40 index of leading shares gained 17%. At year's
100
 95
                                                                         end, it stood at 5,540 points, equivalent to 80% of its historical high
 90                                                                      of 6,944 points, achieved in September 2000. The year’s best-perfor-
 85

      France (FCHI)         United States (DJI)                          ming sectors were commodities, utilities and financial companies.
      Japan (N225)          United Kingdom (FTSE)


                            Source: Reuters                                 Equity-related transactions and corporate restructuring (mergers
                                                                         and acquisitions, leveraged buyouts, share buybacks) were major
                                                                         factors in market performance, enabling banks to increase the share
                                                                         of their revenue derived from activities other than intermediation.
                                                                         This led to strong growth in non-interest income. Recent business
                                                                         trends promoted the gradual shift in major banks’ activities, which
                                                                         started in the last few years, with the growing use of the “originate
                                                                         and distribute” model, whereby banks sell a significant portion of
                                                                         their risk and seek to earn higher fees than in the past




      8
       Banks’ intermediation income under threat
       from the flattening of the yield curve

   Following widespread monetary tightening, the yield curve
gradually flattened in Europe and actually inverted in the USA. In
the euro area, the spread between 10-yr and 2-yr yields narrowed
from 70 basis points in May 2006 to zero by year-end. Expectations
that this term structure would remain the same significantly altered
the macrofinancial environment for the banking sector, changing
the outlook for intermediation income growth, especially since
lending margins are already very thin.

    At the macroeconomic level, the main threat seems to be the
risk that world economic growth will falter. More specifically, in
view of the uncertainty about real-estate markets in the USA, where
a fall in house prices could slow consumption, there is no guaran-
tee that growth in the USA, and in the world economy as a whole,
will continue at the high rates seen in 2006.

   On financial markets, the threat of greater instability must also
be considered, since several risks may combine and compound
each other. Increased risk aversion and higher risk-related costs
could lead to less liquidity on markets and make banks’ risk mana-
gement less effective, especially in the face of extreme shocks.



1.2. All business lines contributed
     to a sharp rise in banks’ earnings
   As was the case for most leading European banks, French credit
institutions published highly encouraging earnings figures for 2006.           Intermediate operating totals
The top three banking groups 1 posted a 23% increase in net conso-                All credit institutions
lidated income attributable to shareholders. On a parent company                      2005 and 2006
basis, aggregate net income for all credit institutions rose 40.9% to                             (EUR billion)
E37.9 billion, partially attributable to the formation of Natixis.      120

                                                                        100

                                                                        80

                                                                        60

                                                                        40

                                                                        20

                                                                          0
                                                                              Net banking      Gross     Operating   Income before      Net
                                                                                income       operating    income      exceptionals    income
                                                                                              income                  items and tax

                                                                                            Source: Commission Bancaire




1   BNP Paribas, Société Générale, Groupe Crédit Agricole.




                                                                                                                                       9
                                                                              A large increase in net banking income offset in part
                                                                              by a decline in the overall bank operating margin

                                                                            The major trends in 2006 point to a sharp increase in earnings.
                                                                         Net banking income (NBI) for the top eight banking groups 1 pre-
                                                                         senting their statements in accordance with IFRS 2 was up 15.9%,
                                                                         larger than the 11.1% increase in 2005. The earnings of the three
                                                                         most internationally active groups were up by an even more
                                                                         substantial 22%. This can be attributed to the very significant contri-
                                                                         butions from foreign subsidiaries and the non-bank business of the
                                                                         French groups, especially in the insurance sector.

                                                                            Most of the leading French banking groups made major acquisi-
                                                                         tions outside their home market in 2006, with a particular emphasis
                                                                         on areas with strong growth potential. These moves modified the
                                                                         groups' profiles substantially by increasing their retail banking
                                                                         assets. This enabled them to achieve higher overall income growth
                                                                         than that resulting solely from retail business in France.

                                                                             This means that retail banking is still the leading source of
 Net banking income by business line                                     profit for the top three banking groups. Its contribution to NBI
      for the three main groups                                          reached 58%. Yet the domestic retail banking market started to slow
                           (EUR million)                                 down in the last quarter of 2006, raising questions about the out-
50 000
                  44 358
                                                                         look for the profitability of this business line. The earnings of
45 000
40 000                                                                   several leading banking groups in 2006 were hit by slower growth
35 000
30 000
                                                                         in fee income, combined with thinner lending margins that were no
25 000           +10,8 %                                       20 313    longer being fully offset by the growth in outstanding loans. Fierce
20 000
15 000
                                      11 418
                                                              +22,6 %
                                                                         competition in the credit market and the likelihood that the yield
10 000
 5 000
                                      +20,6 %                            curve will remain flat or shallowly sloped mean that the current
     0
              Retail              Assets                 Corporate &     unfavourable conditions could last into 2007.
              Bank              management             investment bank

                               2005             2006
                                                                            An examination of all credit institutions’ 2006 earnings shows
                 Source: Commission Bancaire
                                                                         that the overall bank operating margin 3 narrowed yet again, from
                                                                         1.55% to 1.47%. The margin on customer loans also shrank, conti-
                                                                         nuing the trend that started in 2003.




                                                                         1 Groupe Banque Populaire, BNP Paribas, Groupe Crédit Agricole, Groupe Crédit Mutuel, HSBC France,
                                                                          Société générale, Dexia Crédit local, groupe Caisse d’épargne.
                                                                         2 International   Financial Reporting Standards.
                                                                         3 Bank operating margin: ratio of net banking income to total assets + credit equivalent of derivative financial
                                                                          instruments and forward foreign exchange transactions.




         10
   Slower growth of aggregate income in retail banking had
previously been offset by two factors that will not necessarily be
present going forward:

— An increase in corporate borrowing requirements. Companies
  are in a recovery phase and have high working capital require-
  ments, while the propensity to take on debt is being spurred
  by low risk-related costs and a major surge in private equity
  transactions in Europe;

— Strong performance from corporate and investment banking,
  private banking, custody/administration and savings manage-
  ment, which previously boosted growth. Management of savings
  in financial assets received a boost from a massive switch out of
  home savings schemes into life insurance, which also enabled
  banks to write back provisions, which were recognised as income.


   Rising overheads, in line with business growth,
   must be kept in check

    France’s top eight banking groups posted a 10.5% increase in
overheads in 2006 under IFRS. Much of the rise can be attributed to
the effects of acquisitions. On a parent company basis, the data for
all banks are less favourable. Operating costs increased at a faster
rate than in 2005, rising by 11.7% in metropolitan France and by
12.2% on an aggregate activity basis. This increase stems from a
3.3% rise in personnel costs and a 26.3% leap in other overheads.

    Foreign acquisitions and ongoing restructuring of the leading
banking groups should result in economies of scale and improved
risk management through pooling of support functions and facili-
ties. But they also carry short-term costs. When business is expan-
ding rapidly, expenditures must obviously be kept in check to avoid
an excessive increase in operating costs that could erode income in
leaner times.




                                                                       11
                                   Key ratios for the French banking system on a parent company basis
                                                             Aggregate activity

    Selected ratios (%)                                                                               2005          2006
    Average cost of customer funds                                                                    2.41           2.68
    Average return on customer lending                                                                5.30           5.44
    Bank operating margin (1)                                                                         1.55           1.47
    Cost-to-income ratio (2)                                                                         64.30          62.10

    Return on equity                                                                                 11.82          15.61

    (1)   Ratio of net banking income to total assets + credit equivalent of derivative financial instruments
          and forward foreign exchange transactions.
    (2)   Ratio of operating expenses + allocations to depreciation to net banking income.




                                                                          Risk-related costs rose significantly,
                                                                          but remain at historically low levels

                                                                        Risk-related costs were up by an average of 16.7% for the top
        Ratio of risk-related costs to NBI                           eight banking groups. However, they remained at a historically low
        Eight largest groups (under IFRS)                            level of about 3.2% of net banking income, which compares favou-
                     2005-2006                                       rably with the levels of around 8% reached in the early part of the
5,0 %                                                                decade. The slight increase stems partially from major banking
4,5 %
4,0 %
                                                                     groups’ international growth strategies, which sometimes require
3,5 %
                      3,1 %                  3,2 %
                                                                     larger provisions for risk, and strong growth in specialised financial
3,0 %
2,5 %
                                                                     services, which also entails greater risk.
2,0 %
1,5 %
                                                                        Yet the increase in credit risk is still quite small for the time
1,0 %

0,5 %                                                                being. It compares favourably to new threats seen in some
0,0 %                                                                European countries and in the USA in the most aggressive
                   Source: Commission Bancaire                       segments of the mortgage market and the consumer loan market.
                                                                     This means that credit institutions must prepare for a potential
                                                                     downturn in the credit cycle. In the medium term, they should
                                                                     continue setting aside larger provisions in view of the rising level
                                                                     of uncertainty.




          12
      DIVERSIFICATION OF PROFIT SOURCES
2     MAKES INCOME MORE STABLE
      BUT ENGENDERS FRESH RISKS


2.1. New loans and new business
     development call for careful selection
     of borrowers and rigorous management
     of outstanding loans

    Thin profit margins in retail banking
    have spurred banks to seek more profitable
    activities that carry greater risk

   The growth of outstanding customer loans was slower than in                Quarterly growth in housing loans
2005, but it was strong nonetheless. Outstanding loans in metropoli-                end 2004 to end 2006
tan France and in other countries were up by 11.9% as of 31                               (EUR billion)
December 2006, compared with a 14.8% increase in the previous year.     520
                                                                        500
                                                                        480
                                                                        460
                                                                        440
   Home lending was as vigorous in 2006 as in 2005. Buoyed by low       420
                                                                        400
                                                                        380
interest rates and a rising housing market, sustained loan demand       360
                                                                        340

boosted outstandings by 15.6%. Home lending’s share of total
                                                                        320
                                                                        300
                                                                        280

lending to the economy thus rose to 41.9%. This outcome was             260
                                                                        240
                                                                        220
largely attributable to sharp growth in loans to individuals, which
                                                                                     Source: Commission Bancaire
rose by 15.4% and again accounted for the bulk of outstandings
(77.5%). However, margins on this type of lending are still very thin
and must be brought into line with the associated risk, since loans
are granted for increasingly long terms.

   The credit market is bound to remain highly competitive, which
means that margins are unlikely to improve in the near future. The
prospects of increasing domestic market share also looks grim,
since France has one of the highest penetration rates for banking
products in Europe. This means that productivity gains are likely to
become the key to maintaining earnings growth. Furthermore, the
leading banks are also focusing on diversifying their sources of
income and looking for new growth areas, by developing expan-
ding business lines, such as private equity, by producing new
complex market instruments with high value-added or by expan-
ding into international markets offering opportunities for growth.




                                                                                                                   13
                                                              The major banking groups’ choice to expand their international
                                                         business paid off in 2006. In addition to the benefits derived from
                                                         the geographical diversification of income sources, average profita-
                                                         bility levels were higher than those on the domestic market, espe-
                                                         cially in retail banking.


                                                                 New risks, such as those incurred on certain types
                                                                 of structured loans to companies, call for enhanced
                                                                 control procedures

                                                            Helped by sustained business investment, outstandings in
                                                         investment credit increased by a further 9.0%, after 7.5% one year
                                                         previously and 4.9% at end-2004. The continuing prospect of low
                                                         corporate default rates and favourable lending terms sustained the
                                                         strong growth of the market for syndicated loans.

    Syndicated loans and leveraged                           The very rapid growth of the leveraged buy-out (LBO) market in
                buyouts                                  2006 has been noticeable in France, which ranks as the second LBO
  (Europe + the Middle East + Africa)
                                                         market in terms of volume after the United Kingdom 1. The characte-
           from 2004 to 2006
                                                         ristics of LBO deals have changed gradually with financial innovation
GUSD
2 000                                             23 %   and the arrival of new market participants, as well as keener competi-
1 750                                             21 %
                                                  19 %
                                                         tion between credit institutions. The abundance of money in search
1 500

1 250
                                                  17 %   of investments has made it possible to finance deals involving ever-
                                                  15 %
1 000
                                                  13 %   larger targets in a very diverse range of business sectors, as well as
 750

 500
                                                  11 %
                                                         leading to more highly leveraged deals and more complex debt
                                                   9%
 250                                               7%    financing structures.
    0                                              5%

               Syndicated loans (ls)   LBO (rs)
                                                            The increasing use of techniques to transfer credit risk to other
             Source: Thomson Financial
                                                         counterparties has helped to curb the level of risk, despite the
                                                         rapid growth of LBO activity. However, the current situation
                                                         obviously calls for even tighter control of credit quality and enhanced
                                                         portfolio analysis and management. In addition to the diagnosis of
                                                         the French banking system's exposure, which still seems to be fairly
                                                         limited, the increasing interaction between the sources of risk on
                                                         the LBO market needs to be stressed

                                                            The credit quality of LBO deals relies on current favourable finan-
                                                         cing terms continuing, especially in the case of the most recent deals.
                                                         This obviously constitutes a threat. The difficulties in evaluating
                                                         some deals, the use of structures where debt is primarily redeemable
                                                         at maturity (thus deferring the companies’ obligation to repay their




                                                         1 See   the study published in this report: France’s Banking System and Private Equity/LBO Risk.




        14
debts until the end date of the deal), and the growing acceptance of
“convenant-lite” deals mean banks must implement enhanced inter-
nal control systems and price the risks appropriately.

                                                                                Average solvency ratio
   Earnings growth must not be achieved at the expense                              French banks
   of financial soundness                                                             2003 - 2006
                                                                              11,5 %            11,9 %             11,5 %           11,4 %
                                                                       12 %
   The leading French banking groups’ return on equity reached         11 %

very high levels in 2006, matching the average return achieved by      10 %
                                                                        9%
                                                                                       9,2 %             9,0 %              8,8 %
                                                                                                                                             8,2 %
major European and international banks. The diversification of           8%
                                                                        7%
French banks’ business across industrial sectors and geographical       6%

areas played a key role in stabilising earnings over the last few       5%
                                                                        4%

years. However, the expansion of several lines of business, along                         Overall solvency ratio

with strong growth of credit demand, led to a substantial increase                        Tier 1 solvency ratio


in major banks’ risk exposure, even though their solvency ratio                         Source: Commission Bancaire

stopped improving in 2006.

   The potential for a further slowdown in retail banking and an
unexpectedly rapid increase in credit risk means that all banks
must maintain a sound financial foundation and appropriate risk
pricing. This will enable them to cope with the direct and indirect
consequences of extreme shocks and market shifts that their risk
management models do not always take fully into account.



2.2. The need to improve
     identification of deals and risks
     involving non-regulated entities
     and customers
   With the steady increase in legal risks and the more rigorous
governance recommendations issued by the Basel Committee in
February 2006, the Commission Bancaire paid careful attention to
compliance with the good governance principles. This entails
in-depth discussion of how relationships between banks and unre-
gulated entities –chiefly hedge funds – are handled and the current
international and domestic efforts to fight money laundering and
terrorist financing.




                                                                                                                                             15
             Stepping up the fight against money laundering
             calls for closer monitoring of customer transactions

         The Commission Bancaire’s supervision of more than 1,700
     authorised entities, which include bureaux de change for these
     purposes, is a key element in the fight against money laundering and
     terrorist financing. Its role as the competent authority in this area is
     to ensure that institutions implement effective vigilance procedures
     to prevent criminal funds from entering or transiting through the
     financial system. Enhancing internal control systems to ensure com-
     pliance with international requirements is a priority in this regard.

        At the international level, the General Secretariat of the
     Commission Bancaire also took part in the work of the Basel
     Committee on Banking Supervision to introduce an approach to
     the risks arising from banks’ due diligence with regard to the know-
     your-customer procedures advocated by the Financial Action Task
     Force. It played an active part in setting up a working group to
     ensure convergence in European Union banking supervisors’
     enforcement of the new harmonised framework, which should
     come into force in 2008.


             Credit institutions need to improve
             their understanding and management
             of counterparty risks involving hedge funds 1

        With the expansion of business involving hedge funds, banking
     supervisors are increasing their efforts within an enhanced interna-
     tional cooperation framework to improve market discipline so that
     banks give due consideration to sound management of the credit risk,
     market risk, liquidity risk and model risk involved in such business.

         In addition to having adequate regulatory capital, which provides
     banks with a necessary safety cushion for the risks incurred, the
     best way for banks to protect themselves from the risks incurred in
     transactions with hedge funds is to have robust internal risk mana-
     gement systems. Special attention must be paid to four factors:
     first, banks’ access to comprehensive information about their high-
     ly leveraged counterparties; second, greater consideration of colla-
     teralisation policies and the quality and transparency of credit risk;




     1 See "Indirect supervision of hedge funds", in the FSR special edition on hedge funds
      by the Banque de France, April 2007.




16
third, real improvements in the measurement of risk exposure to
complex instruments (including model risk); and fourth, improve-
ments in stress testing, particularly with regard to liquidity risk.

   Banking supervisors intend to step up efforts to improve risk
management systems: Pillar 2 of the Basel II Framework should
result in greater emphasis on some of the risks most closely asso-
ciated with exposure to hedge funds, such as liquidity risk, concen-
tration risk, extreme risk and model risk.




      THE COMMISSION BANCAIRE PAYS SPECIAL ATTENTION
3     TO THE WAY THAT CREDIT INSTITUTIONS
      ARE IMPLEMENTING THE NEW REGULATORY FRAMEWORK

3.1. Focus on appropriate implementation
     of the new Basel II Framework

    The Commission Bancaire is continuing
    its assessment of internal risk measurement
    and management approaches

    The European Council and the European Parliament formally
adopted the Capital Requirements Directive (CRD) for credit insti-
tutions and investment firms on 14 June 2006. The CRD is a key step
in ensuring that the new capital adequacy framework (Basel II) esta-
blished by the Basel Committee on Banking Supervision is imple-
mented within the European Union. In France, the Decree of 20
February 2007 on capital requirements for credit institutions and
investment firms and Order 2007-571 of 19 April 2007 transpose this
framework into law and complete the transposition process started
by the General Secretariat of the Commissin Bancaire in autumn
2004. This process was carried out in close consultation with the
financial industry and the General Directorate of the Treasury and
Economic Policy, before being examined by the Advisory Committee
on Financial Legislation and Regulations and by parliament.




                                                                       17
        The three pillars of the Basel II Framework, i.e. minimum capital
     requirements, supervisory review process and market discipline,
     provide a prudential structure that is both more comprehensive
     and more sensitive to the risks that institutions actually incur. They
     also encourage institutions to improve their internal risk manage-
     ment systems. The summary of the findings of the Fifth
     Quantitative Impact Study (QIS5) published on 24 May 2006 showed
     that the overall framework was adequately calibrated and that the
     intended hierarchy of the different approaches to risk measure-
     ment was achieved by imposing smaller capital charges in exchange
     for using more sophisticated internal-ratings-based (IRB) approa-
     ches. Supervisors are now stressing the need to assess the manner
     in which banks implement these approaches, especially the IRB
     approaches to credit risk and advanced measurement approaches
     for operational risk. On 4 April 2006, the Committee of European
     Banking Supervisors (CEBS) published guidelines on the imple-
     mentation, validation and assessment of these approaches.

        In autumn 2005, the General Secretariat of the Commission
     Bancaire started a series of on-site inspections to assess the systems
     and models implemented by French banks. These inspections
     continued in 2006 and 2007. They take place after the General
     Secretariat of the Commission Bancaire receives the “internal vali-
     dations” that the banks have carried out to ensure that they comply
     with the minimum requirements set out in laws and regulations,
     and, more generally, to ensure the quality of the systems, their use
     and control environment, and the estimated risk parameters. Each
     on-site inspection results in a report that is examined by the
     General Secretarit of the Commission Bancaire, which consults
     with the bank to set a timetable for any corrective measures requi-
     red. The timetables, along with the inspection reports, are presen-
     ted to the full Commission Bancaire, which rules on the formal
     application to use approaches developed by the institutions them-
     selves. In the case of institutions planning to adopt the Basel II
     Framework in 2008, the Commission Bancaire’s decisions will be
     announced by the end of 2007. These decisions will take account of
     any remarks made by other European banking supervisors in the
     case of institutions doing business in several countries. For this pur-
     pose, Article 129 of the CRD sets a six-month consultation period
     after the date of the application made to the home supervisor.
     During this period the host supervisors in the other European
     Union countries are free share their assessments of the applicants.




18
       These assessments show that further improvements
       are apparently needed

   The preliminary findings of the inspections and their examina-
tion by the Commission Bancaire show that most institutions need
to make improvements in many areas.

   Under Pillar 1, the improvements primarily concern the defini-
tion of default and the construction of uniform risk classes, as well
as collecting and estimating Basel II parameters, such as probability
of default (PD) and loss given default (LGD). This calls for banks to
make gradual improvements in their historical data so that they
provide satisfactory coverage of full business cycles. Other impro-
vements under Pillar 1 include use-tests of the IRB approaches in
day-to-day risk management and uniform implementation of such
approaches for all exposures, as well as ongoing control procedures
and validation of the information systems and/or models used. This
requires a benchmarking process and rigorous backtesting, which
is crucial in this context. It also calls for independent
internal certification procedures for the models used. When expert
systems are the only means used for rating and assessing expected
losses on a given portfolio, further information provided by more
systematic decision-making aids is crucial.

    Furthermore, in addition to the assessment of internal risk mea-
surement and management systems under Pillar 1 (minimum
capital requirements), the Commission Bancaire also places special
emphasis on banks’ assessment procedures for adjusting their capi-
tal to their risk profile for the purposes of Pillar 2 (supervisory
review process). In keeping with the recommendations published
by CEBS on 25 January 2006, the Commission Bancaire intends to
ensure that the Internal Capital Adequacy Assessment Process
(ICAAP) factors in risks that Pillar 1 fails to cover adequately, inclu-
ding concentration risk, liquidity risk and overall interest rate risk 1.

   A main concern is to develop more comprehensive stress tests
that encompass different risks (credit risk, market risk, etc.) and
cover all exposures. Enhanced efforts are also required for more
specific simulations of indirect risks, such as market risk, factoring
in chaotic unwinding of similar positions held by several banks in
narrow markets, and for the modelling of different aspects of liqui-
dity risk.




1   See the study published in this report: "Overall interest rate risk management at French banks:
    what will Basel II change?"




                                                                                                      19
        In addition, the General Secretariat of the Commission Bancaire
     will then undertake an in-depth examination of how banks have
     implemented their internal assessment process.

         Particular attention will also be paid to aspects relating to corpo-
     rate governance and how it contributes to the effectiveness of inter-
     nal control systems, especially with regard to risk measurement,
     management and monitoring. For this purpose, the General
     Secretariat of the Commission Bancaire published the criteria and
     methodology chosen by the Commission Bancaire for implementing
     its Supervisory Review and Evaluation Process (SREP). This informa-
     tion was posted to the Banque de France and CEBS websites in com-
     pliance with the transparency requirements set out in the CRD, as
     well as with the CEBS principles on supervisory disclosure 1, after
     consultation with the banking industry.

        Banks also need to comply with the transparency requirements
     set out under Pillar 3 (market discipline) and to adopt procedures for
     assessing the appropriateness of their publications, along with the
     publishing schedule and verification procedures. This is especially
     important since the authorisation that the Commission Bancaire
     grants to use certain approaches may depend on compliance with
     these requirements, which are coordinated with the requirements
     set out in the new International Financial Reporting Standards.



     3.2. Convergence of supervisory practices
          in the European Union is accelerating
          under the auspices of CEBS
        International cooperation between banking and financial supervi-
     sors has led to many initiatives aimed at improving the convergence
     of supervisory practices. In the more specific case of CEBS, several
     projects have been developed under the French presidency in recent
     months to give the Committee the tools and instruments it needs to
     enhance convergence and cooperation between EU supervisors.


            Implementation of decentralised European supervision
            of large groups is spreading

        The General Secretariat of the Commission Bancaire intends to
     continue contributing in a major way to CEBS’s work on operational
     networking between home and host supervisors of major

     1   See the box in the second part of the report (Activity of the Commission Bancaire and its General
         Secretariat) on Basel II.




20
European banking groups to expand day-to-day exchanges, coordi-
nation and cooperation between supervisors. These colleges of
supervisors have come up with practical solutions to the main
problems associated with the implementation of Basel II for such
groups. The lessons learned from this work could be extended to
developing and structuring cooperation between supervisors. In
the same vein, the determination to promote a European supervi-
sory culture means that the General Secretariat of the Commission
Bancaire will expand its participation in joint training activities
carried out by CEBS and expand exchanges of staff with other
European supervisors.

    CEBS also finalised the definition of a joint recognition procedure
for external credit assessment institutions, and published recom-
mendations regarding the supervisors’ authorisation of internal
credit rating systems and advanced operational risk measurement
systems. The General Secretariat of the Commission Bancaire now
follows this procedure when examining applications from French
credit assessment institutions applying for recognition so that their
ratings can be used by banks that opt for the Standardized Approach
to credit risk measurement. In more general terms, CEBS set up a
working group on convergence in 2006 to ensure that the recom-
mendations made in the report by the European Commission’s
Financial Services Committee are implemented. The General
Secretariat of the Commission Bancaire contributes actively to this
group’s work. The working group intends to come up with practical
solutions to enhance the convergence of supervisory practices. It is
focusing on mediation, peer review, development of an impact study
methodology and delegation of tasks between supervisors.


   Convergence of supervisory practices will move
   forward in 2007 with the introduction of common
   accounting and prudential reporting formats
   for all European countries

   Greater convergence in supervisory practices is in line with the
current decentralised European supervisory framework and illustra-
ted by the establishment of a harmonised European prudential
reporting framework (COREP) based on Basel II, and a financial
reporting framework (FINREP) based on IFRS. The Commission
Bancaire’s adaptation of the European reporting formats resulted in
the formalisation of the French FINREP and COREP statements, fol-
lowing in-depth consultations with the banking industry conducted
by the General Secretariat of the Commission Bancaire. The final
versions of the COREP and FINREP taxonomies were published in




                                                                        21
                                                                France on 5 February 2007 and posted to the Banque de France
                                                                website, along with supplementary information that banks will use
                                                                for filing their reporting statements with the General Secretariat of
                                                                the Commission Bancaire. The date for the first filing of the new
                                                                formats has been set for 30 June 2007 and banks will have longer
                                                                filing deadlines for the first two years. The filings will be made using
                                                                the new XML-XBRL data exchange format recommended by CEBS.




                                                   Key data for the french banking system
                                                  Parent-company basis - Worldwide activity

(EUR billion)                                                             2005                               2006                           Annual
                                                                                                                                          change (%)
Total assets                                                              5 275                              6 041                           14,5
Customer lending                                                          1 684                              1 844                           11,9
Securities portfolios                                                     1 088                              1 253                           15,2
o/w trading securities                                                     657                                 776                           18,1
Total assets of foreign branches                                          1 031                              1 130                           9,6
Customer deposits                                                         1 376                              1 484                           7,8
o/w demand deposits                                                        426                                 454                           6,6
o/w special term savings accounts                                          633                                 634                           0,1
Outstandings in derivative financial instruments (1)                     51 319                             64 774                            26,2

(1)   These notional amounts are indicative of trading volumes in these markets; they do not reflect the associated risks.




Provisional results for 2006                                              2005                               2006                           Annual
(EUR billion)                                                                                                                             change (%)
Net banking income                                                         89,5                              103,3                           15,4
Capacity costs      (1)                                                    57,6                               64,2                           11,5
Gross operating income                                                     32,0                               39,2                           22,5
Net allocation to provisions and
bad-debt write-offs                                                         1,3                                1,4                           3,2
Operating income                                                           29,5                               38,9                           31,8
Income before exceptional items and tax                                    31,3                               45,8                           46,4
Net income                                                                 26,9                               37,9                           40,9

(1)   Operating expenses + depreciation and amortisation expense and allocations to provisions for tangible and intangible fixed assets.




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