Basel II and Microfinance: Exercising National Prerogatives

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1 Draft April 2005 Basel II and Microfinance: Exercising National Prerogatives Kathryn Imboden, Women s World Banking 1 Introduction The International Convergence of Capital Measurement and Capital Standards, a Revised Framework, commonly referred to as Basel II or the New Capital Accord, was approved by the Basel Committee on Banking Supervision (BCBS, or Basel Committee) in May 2004 and endorsed by the G-10 countries in June Developed under the auspices of the Basel Committee, it will succeed the 1988 Basel Accord in establishing minimum required regulatory capital levels for internationally active banking institutions, as well as the broader financial community at the discretion of national supervisory authorities. 2 Basel II is designed for internationally active banks in the member countries of the Basel Committee; its application will extend however to other countries, as is the case for the previous Basel I Accord. Respecting the Basel requirements has become synonymous with sound banking practices and the maturity of a national financial system and its institutions. (Basel I applies to the same group of banks, but has now been implemented in over 100 countries.) It is anticipated that Basel II will be applied in the 13 Basel Committee member countries 3 as of end 2006, and during the period for a large number of emerging market countries, in most cases, and ideally, through implementation plans and timeframe tailored to the national context. Some countries will choose to address other supervisory priorities before tackling Basel II, e.g. the implementation of the BCBS Core Principles on Banking Supervision. 4 Basel I remains an option for supervisors and banks 1 Prepared by Kathryn Imboden, with Lloyd Stevens, for Women s World Banking. The views expressed are those of the authors. 2 Full information on the New Capital Accord, including the complete texts, can be found on the BIS web site: 3 Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. 4 See 1

2 in countries which do not choose to implement Basel II. It is intended that countries should move to Basel II only when they are ready. This short paper outlines the basic parameters of Basel II and the application in emerging markets and looks at the issues at two different levels: (1) systemic issues of Basel II implementation and the inclusion (or not) of microfinance (Part 2) and (2) actual changes in affecting microfinance firstly, the capital adequacy requirements of microfinance institutions, and other financial institutions with microfinance portfolios (as lenders) (Part 3), and secondly, the borrowing capacity of microfinance institutions in financial markets, notably from banks subject to Basel II standards (Part 4): Part 1 provides background information on capital adequacy, Basel I and Basel II. Part 2 provides information on the extent of planned application of Basel II in emerging market/developing countries and raises systemic issues Part 3 outlines the likely impact on supervision of MFIs and MF portfolios Part 4 introduces considerations of access to capital for MFIs Part 5 draws conclusions. Assessing the impact of Basel II on microfinance leads us to outline five considerations, around which the paper is built. The first, second and fifth point relate to broader systemic issues of supervision. The third and fourth points relate to issues of implementations of Basel II in terms of microfinance institutions as borrowers. 1. The impact will depend on the degree of implementation in developing countries. Even in countries implementing Basel II, supervisory authorities will not apply the new Framework to all supervised financial institutions in their jurisdiction. In many countries, more progress in the application of the Basel Core Principles of Banking supervision is a pre-condition for the application of Basel II. Supervisory authorities would be well advised to weigh the pluses and minuses of applying the new Framework. While Basel II has become synonymous with advanced banking supervision, it was never the intention of the Basel Committee for supervisory jurisdictions to apply Basel II prematurely. 2. It is critical that national authorities analyze what is needed in a country in relation to the state of development of the banking sector and supervisory capacity. Other supervisory priorities may need to be addressed first, before Basel II is implemented. (consolidated supervision, implementation of internationally recognized accounting standards, proper valuation techniques, functioning regal environment). Where Basel II is implemented, the administrative burden for both financial institutions and supervisory authorities will be significant, even for the simplest options. Preparing the basics and sequencing the steps of implementation make sense. In the big picture, it is about taking the right steps to strengthen trust in the financial system, through building the effectiveness of supervision and establishing the core 2

3 infrastructure required for building a sound and effectively supervised financial sector Basel II is based on the adoption of risk-based supervision, 5 a change in thinking and procedures for both financial institutions and supervisory authorities in many countries. Much focus is put on the impact of the various approaches to calculate credit risk under Pillar 1. Not to be underestimated are the importance of Pillar 2 (supervisory review) and Pillar 3 (market discipline). 3. If Basel II were to be applied to the microfinance institutions, a more lenient risk categorization for retail loan portfolios, to which microfinance portfolios correspond, under Basel II could theoretically impact MFIs. This is however not expected to be the case for microfinance portfolios. Supervisory authorities have the right, expressed explicitly in the Framework, to apply risk weightings as they see fit. Risk weightings are not expected to change. 4. More important is the concern about a possible decrease in access to capital by microfinance institutions (and other financial institutions and enterprises in developing countries) because of higher risk categorization for microfinance institutions as borrowers. More generally, there is concern that the application of Basel II will lead to reduced international capital inflows in emerging market countries overall. Analysts are in disagreement regarding the impact of Basel II on capital inflows in emerging market countries. 5. When applied reasonably in function of the national context, Basel II, while criticized for its complexity, can be a force in improving supervision at the systems level and management of risk at the institutional level. Whether via Basel II or via progress in the implementation of the Basel Core Principles, financial institutions stand to gain. Improved risk management at the institutional level and improved supervision at the systems level is a fundamental condition of increased financial integration. National supervisory authorities need to make the right choices in terms of pragmatic implementation; financial institutions, including microfinance institutions, need to engage in dialogue to make their risk profiles better understood. 5 Risk based supervision entails shifting emphasis towards the quality of bank s risk management processes, and away from the hands-on evaluation of individual loans in the portfolio. 3

4 Part 1. Background From Basel I to Basel II 1.2. The Principles of Capital Adequacy Capital is the underpinning of a financial institution. At an institutional level, capital serves: To absorb unanticipated losses in assets with enough margin to inspire confidence and enable the financial institution to continue To protect creditors including depositors, bondholders and other creditors in the event of insolvency and liquidation To protect insurance funds (where deposit insurance exists) and taxpayers To protect owners against increases in insurance premiums To fund investments in branches and other real investments To improve incentives for owners to oversee the financial institution s operations (incentive value of capital) To ensure continued operations even in hard times The Basel Committee is concerned with capital adequacy as a means to absorb risk when losses are experienced at the institutional level, thus strengthening the soundness and stability of the banking system and encouraging on-going improvements in risk assessment. Financial instability is costly to an economy (disruption in distribution of funds, breakdown in payments systems, and the risk of international contagion). Capital regulation is a useful and crucial tool to protect against financial instability. Capital regulation has competitive implications, as it offers internationally harmonized rules for internationally active banks competing with each other. Under both Basel I and Basel II, the minimum capital requirement is expressed in terms of the proportion of total capital to risk-weighted assets, riskier assets therefore entailing a higher level of total capital: Total Capital Minimum Ratio = = > 8% Risk Weighted Assets 4

5 1.2. The Basic Parameters of Basel I Under the 1988 Capital Accord 6, established for internationally active banks in G-10 countries, capital requirements are designed to cover credit risk only (with an amendment to add market risk arising from trading activities, introduced in 1996). Assets are risk weighted according to a simple structure (0, 20, 50, 100%) and the bank s total capital (Tier I and Tier II 7 ) to risk-weighted assets must be greater than or equal to 8%. This accord created an internationally recognized standard, contributed to financial stability and was relatively simple. It did not however always capture risks in a bank other than credit and market risk, does not take into consideration innovation in risk measurement and management or new products developed since Furthermore, it divided the world into OECD and non-oecd countries The Basic Parameters of Basel II Basel II is designed to remedy some of the shortcomings of Basel I. One of the main goals of Basel II is to create a more risk sensitive measurement of capital. This enhanced framework makes use of the roles played by bank management and the market, better aligns regulatory capital to underlying risk, encourages banks to improve risk management capabilities, offers more comprehensive coverage of risk and is applicable to a wide range of banks and systems. Under Basel II, the definition of capital is unchanged and the 8% minimum capital requirement is unchanged. Basel II is a structure composed of three pillars (see below). It relies more on the banks own assessment of risk, recognizes risk mitigation techniques, and includes a capital charge for operational risk. (See below.) It offers a menu of options from which to choose. Basel II introduces supervisory review (See below.) and market discipline in addition to minimum capital requirements and it increases the risk sensitivity of the minimum capital requirements. Securitization, not treated under Basel I, is treated under Basel II. 8 This is a schematic view of the New Accord: 6 The rules established in the Basel capital accords are not binding in and of themselves, as they must be adopted by the appropriate regulatory authorities to have effect. They are guidelines. 7 Tier I capital is core capital, this includes equity capital and disclosed reserves. Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt. 8 There is an interesting and informative instrument to navigate through the layers, and options, of Basel II (The Basel II Navigator), made available on-line by Price Waterhouse Coopers in Hong Kong. See 5

6 Outline of the New Accord Basic Structure Three Basic Pillars Minimum Capital Requirements Supervisory Review Process Market Discipline Risk-Weighted Assets Definition of Capital Credit Risk Operational Risk Market Risk Core Capital Supplementary Capital Standardized Approach Internal Ratingsbased Approach Basic Indicator Approach Standardized Approach Advanced Measurement Approaches Standardized Approach Models Approach Basel II is built on three mutually reinforcing pillars : 1) minimum capital requirements; 2) the supervisory review process; and 3) the effective use of market discipline (public disclosure). No one pillar is more important than the others. In terms of Pillar 1, although the proposed new Accord carries over from the 1988 Accord both the current definitions of capital and the minimum 8% requirement of capital to risk-weighted assets, its calculation of credit risk has changed considerably and operational risk has been added (market risk being unchanged from the 1996 amendment to Basel I). o Pillar 1 provides a choice of approaches in determining credit risk, the Standardized Approach (plus a simplified Standard Approach) or the Internal Ratings Based Approach. More sophisticated banks can choose the more complex capital requirement approaches, which are more accurate. As under the previous Accord, banks are obliged to slot their exposures into risk categories based on observable characteristics of the exposure. It retains the approach of risk buckets from the 1988 Accord, and therefore some of its drawbacks. The new approach greatly expands the number of risk buckets, however, and therefore the migration of credits across ratings categories is considerably smoother than under the current Accord. Unlike the 1988 Accord, where, for example, all commercial credits, regardless of quality, are assigned a 100% risk weight, risk 6

7 categorization is based on external ratings (e.g. Moody s, S & P). This will however rarely come into play in emerging markets. Where no external rating is applied to an exposure, the standardized approach mandates that in most cases a risk weighting of 100% applies, implying a capital requirement of 8% as in the current Accord. Two important innovations in the standardized approach are that lower risk weights are assigned to other retail and residential mortgage loans and that loans past due are risk weighted at 150%, unless a threshold amount of specific provisions has been set aside. In order to assist bank and national supervisors where even the standardized approach is too advanced, i.e. where a broad range of options is not yet necessary at this point in the financial sector development of the country, a simplified standardized approach has been prepared, offering the simplest options to calculate risk weighted assets. o o New under Basel II, operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, human resources or systems, or external events; in general, the basic indicator and standardized approaches require banks to hold capital for operational risk equal to a fixed % of the bank s income, either on an aggregated basis or broken down into eight business lines. A capital charge for operational risk is not an option, but rather a fundamental part of Basel II. Market risk, covering risks in the trading book of debt and equity and foreign exchange and commodity risks, is treated in the same way as in Basel I. Pillar 2 introduces supervisory review, based on a series of guiding principles, all of which point to the banks need to assess their own capital adequacy positions relative to their overall risks and for national supervisors to review and take correction action in function of the results. While Pillar 1 is a mechanical approach that ensures that the bank meets minimal capital requirements (i.e. 8%), Pillar 2 allows the bank and supervisors to determine the optimal level of capital given the institutions particular risk profile. This is based on a strong risk-based supervisory review with the capacity of early identification of weaknesses. Pillar 3 introduces requirements for market discipline (transparency, public disclosure). Timely and reliable disclosure of a banks financial information permits market participants to assess a banks activity and the risks inherent on these activities, and act accordingly. Market discipline is designed to be an effective complement to supervisory efforts to encourage banks to maintain sound risk management systems and practices. Some countries will begin by achieving consistency among financial institutions by applying a baseline level of 7

8 financial disclosure applicable to all supervised institutions. (covering such items as foreign exchange risk and commodity risk??) Supervisors are encouraged by the Basel Committee to apply the principles underlying Pillars 2 and 3 even before they move to Pillar 1 implementation. Accepting the principles of the three pillars is a commitment to improved supervisory practices, regardless of what measure of credit risk is adopted (including retaining Basel I). Part 2. The Adoption and Application of Basel II in Emerging Market/Developing Countries It is not yet certain how soon many countries will adopt Basel II. 9 Whereas over 100 countries have applied Basel I, there is evidence that many emerging market countries will not be applying the Basel II requirements at all or for all institutions, at least not initially. 10 In response to an early 2004 questionnaire from the Financial Stability Institute, 11 eighty-eight non-bcbs jurisdictions indicated, however, their intention to adopt Basel II, most of them in the time period. 12 While the reasoning behind Basel II is generally accepted by central banks, implementation timetables are quite something else. In many jurisdictions, supervisors and banks are not yet ready, and will not be ready for some years to come. In these cases, the approach under Basel I will remain valid, or country specific capital adequacy requirements will be introduced. In some cases, emerging market countries are adopting a wait and see attitude. 13 A decision by authorities in almost all developing countries not to apply Basel II immediately would be indeed a good thing. Other supervisory priorities (consolidated 9 The US indicated in June 2003 that it would apply Basel II only to around 10 large internationally active banks. While only a handful of financial institutions are required by U.S. regulators to comply with Basel II, many smaller institutions are actively evaluating the benefits to be gained by compliance as well. The implementation deadline in the U.S. is early The EU regulations will introduce Basel II for all banks and securities firms, and this may set a precedent for other countries; its CAD3 (Capital Adequacy Directive) transposes Basel II into E.U. legislation. An interesting treatment of the challenges for Basel II implementation in mid-sized banks is found in the Economist Intelligence Unit s Weighing Risk: Basel II and the challenge for mid-tier banks, October China has indicated that its banking system is not ready for Basel II, expressing also the concern that the new capital requirements will be too stringent. India is on board, but the debate is on-going as to how to implement; the approach of the Reserve Bank of India is one of gradual convergence with international standards and best practice with suitable country specific adaptation; a road map is to be defined by December 2004, according to a May 2004 Policy Statement of the RBI. 11 The FSI was created by the BIS and the BCBS to assist supervisors around the world in improving and strengthening their financial systems. 12 BIS, Financial Stability Institute, Implementation of the new capital adequacy framework in non-basel Committee member countries, Occasional Paper, No. 4, July The paper and the supporting regional studies are available from the BIS web site. 13 Concern has been expressed that institutions in non-g10/non-eu countries applying the standardized approach will have to increase capital levels more than institutions in those countries applying the foundation IRB approach, including for retail exposures. This would result in implicit pressure to implement more sophisticated approaches. 8

9 supervision, implementation of internationally recognized accounting standards, proper valuation techniques, functioning regal environment) need to be addressed first, before Basel II is implemented. For example, Basel II requires complete and accurate financial statements as a starting point. The application of Basel II entails a significant administrative burden on financial institutions and supervisory authorities, necessitating putting systems into place whose sophistication goes beyond that of current practice. Supervisory resources and capacity are also an issue. 14 The shopping list of what banks in emerging markets will be required to do to apply the standardized approach of Pillar 1 is extensive. 15 It will be particularly costly, in relative terms, to implement for small developing countries. Both financial institutions and supervisors will need to upgrade skills in the areas of credit risk mitigation and operational risk under Pillar 1 as well as supervisory systems under Pillar 2. Adequately trained staff is a prerequisite for making Basel II work. Preparing the basics and sequencing the steps of implementation make sense. Not to be underestimated are the extent of changes on the legal and regulatory front. Many countries will need to amend legislation and regulations to provide the legal basis for modifying supervisory methods in order to respect Basel II. In addition, the adoption of international accounting standards, sound asset valuation rules and realistic loan loss provisioning are all necessary to be sure that the capital ratios will reflect meaningfully the capital adequacy of the financial institution. Furthermore, in the context of Basel II, supervisors are encouraged to move towards a system of risk-based supervision; this means shifting their emphasis towards the quality of bank s risk management processes, and away from the hands-on evaluation of individual loans in the portfolio. A key element to consider is whether a good baseline supervisory system is in place. Supervisors will want to know to what extent the Basel Core Principles are successfully implemented. Moving into more sophisticated methodologies for the calculation of regulatory capital is a secondary consideration. Supervisors may need to devote resources to set basic prudential standards. The Basel Committee itself acknowledges that the adoption of Basel II may not be the first priority for all non G-10 countries in terms of what is needed to strengthen supervision, notably the implementation of the Core Principles. The BCBS encourages national supervisory authorities to consider the benefits of the new Framework in their own country contexts. The Committee nevertheless encourages supervisors to implement key elements of the supervisory review, transparency and market discipline (Pillars 2 and 3) even if the Basel II minimum capital requirement methodology under Pillar 1 is not 14 A 2003 article in the DFC Spotlight ( How Will the New Basle Accord Affect Risk Management in Emerging Market Banks? DFC Spotlight, June 2003) discusses the ramification of Basel II for banks and explains the necessary procedures and analytical tools for the adoption of modern risk management techniques. 15 The Economist has described Basel II as fiendishly complicated. (May 15, 2004). 9

10 implemented by the given jurisdiction (i.e. Basel I methodology retained). The Chairman of the Basel Committee laid this out as follows: National authorities in each country should assess their priorities and their industry s readiness carefully. They should adopt Basel II especially the more advanced approaches to credit and operational risk only when it is most appropriate in light of national circumstances. National authorities can take various steps to asset them in transition, such as beginning to apply the principles set out in pillars two (supervisory review) and three (market discipline) once they have assured themselves that the fundamentals of effective supervision are in place. 16 The IMF and the World Bank, when conducting financial sector assessments will continue to base their analysis on the adequacy of the regulatory/supervisory standards and subsequent performance, regardless of whether the country is operating under Basel I or Basel II. Finally, it is important that national authorities determine what is appropriate. Supervisors will need to balance the costs and benefits of implementing the new Framework against other national or supervisory priorities, such as building the effectiveness of supervision and establishing the core infrastructure required for building a sound and effectively supervised financial sector. In the big picture, it is about taking the right steps to strengthen trust in the financial system. Part 3. Implications for Regulated Microfinance Institutions and Microfinance Portfolios of other Regulated Financial Institutions This section investigates the potential impact of Basel II on regulated microfinance institutions as lenders, as well as on the microloan portfolios of other institutions for which microfinance is one business line Application to Regulated MFIs as Lenders Will Basel II apply to Microfinance Institutions and Microfinance Portfolios? Basel II is intended to be applied, or not, in relation to national supervisory priorities. When applying the new Framework, supervisors can chose to which institutions Basel II will apply within their jurisdiction. Recall that Basel II means not only introducing more complex calculations of regulatory capital under Pillar 1, but also the introduction of riskbased supervision under Pillar Jaime Caruana, Chairman of the Basel Committee, interviewed in The Banker, September 2,

11 ALL the suggested criteria for determining the population of banks to which Basel II would apply exclude MFIs: 17 Size of the bank (e.g. share of assets in the banking system; Nature and complexity of its operations; Involvement in significant activities or business lines; International presence; Interaction with international markets Bank s risk profile and risk management capabilities, and Other supervisory considerations (resources available and trade-offs between complexity of supervision and increased sensitivity of resulting capital requirements. On the basis of this recommendation, supervisory authorities would not apply Basel II to regulated microfinance institutions. (The application to microloan portfolios of larger institutions, for which microfinance is one business line is another consideration. See below.) Capital Requirements if Basel II were applied to Regulated MFIs In countries where Basel II is applied, some analysts have expressed concern for an disproportionate increase in current capital requirements for banks in developing countries, while recognizing the fact that banks should hold higher capital in relation to higher levels of risk. Others have expressed concern that capital requirement will be weakened. Changes were made in November 2001 to decrease the regulatory impact on lower-rated emerging market countries. The results of the 2003 Third Quantitative Impact Study are not conclusive: under the standardized approach, there is an estimated 11% increase in the capital requirement for G-10 countries and 12% for a (disparate) group of Other countries, not a statistically significant difference, nor meaningful in relation to the wide range of other countries. While national supervisory authorities have the possibility, and the responsibility, to apply Basel II (or not) as fitting to the national context, it is possible to explore the likely outcome of the application of Basel II to microlending. Pillar 1 Credit Risk under Pillar 1. The Standardized Approach under the new Accord is a more refined version of the 1988 Accord and is the simplest to implement. It is this approach that would be applied for the most part in developing countries. 18 It is the 17 Basel Committee on Banking Supervision, Implementation of Basel II: Practical Considerations, July 2004, p The Internal Ratings Based Approach will be available only to institutions with more advanced internal risk measurement systems. As such, it is likely to be adopted only by the major global banks. Most banks around the world will use the standardized approach. Although fewer in number than the banks using the Standardized Approach, the IRB banks will tend to be the most powerful in setting norms and standards 11

12 approach that regulated micro-finance institutions required to adhere to the new Accord are likely to apply. 19 Since micro-entrepreneurs are certain to be unrated, a straightforward interpretation of the new Accord is that regulated MFIs would face no change in required capital. Under both the existing and new Accords, their unregulated borrowers would require 100% capital. However, in addition to being unrated, most micro-finance portfolios are also extremely granular (i.e. very low aggregate exposure to any single counterpart). According to the proposed new Accord, then, this portfolio will likely be deemed other retail, the same risk categorization as small & medium-sized enterprises ( SME ) loans. 20 Various constituencies, notably the European SME sector, lobbied successfully for a reduced regulatory capital for their retail portfolios 75%. This means that an institution which must set aside 100% X 8% of its portfolio under the current Accord will only need to set aside 75% X 8% under the new. (This conclusion is supported by the initial results from QIS III The banks with the greatest reduction in capital requirements are those banks with a large proportion of retail activity. 21 ) In this way, the new Accord could theoretically benefits regulated micro-finance institutions by reducing regulatory capital. For a regulated micro-finance institution s own required capital perspective, one possible impact of Basel II could come, in theory, from this risk categorization of small & medium-sized enterprises ( SME ) loans. 22 This category is expected to comprise the bulk of a microfinance bank s portfolio. For credit (such as tenor, pricing, etc.) and will likely dominate the Basel II operating environment. The IRB approach relies upon a continuous gradation of risk, as determined by the bank s internal methodology (which must be a proven indicator of risk based on a strong historical track record). At the same time, the new Accord assigns increasing capital to borrowers on an exponential, rather than linear basis, based upon the level of credit risk that they pose to the institution. This results in higher levels of required capital for borrowers with a higher probability of default. In a cyclical downturn, probabilities of default will rise, increasing required capital and potentially choking off credit to weaker borrowers, exacerbating the downturn. As such, the new IRB approach may amplify the economic cycle even more than the existing Accord and creates more volatility in capital requirements. Results of the Quantitative Impact Study 3 indicated that capital requirements overall would be slightly lower under the Basel II IRB approach than under Basel I. 19 Several prominent shortcomings of the existing Accord are addressed, such as its inadequacy in terms of risk sensitivity, its bias toward short-term lending and its distinction between OECD and non-oecd countries (whereby preferential risk weights were given to OECD countries in certain circumstances). 20 The World Bank had expressed concern that the definition of retail and SME lending reflects standards prevailing in large industrial countries does not appropriately capture the risk features of smaller size firms in smaller countries. 21 Quantitative Impact Study 3 Overview of Global Results, Bank for International Settlements, May 5, It is interesting to note that the comments to the QIS3 included continued lobbying for fair treatment (read better ) of SMEs and small banks, while at the same time one supervisory agency expressed the need for discretionary power to increase the risk weightings for SME lending. Of particular interest to our discussion are fears expressed that the Accord will penalize low-risk financial institutions such as credit unions. This does not appear to be the case. 12

13 risk, the capital requirement for regulated MFIs could theoretically be lower under Basel II than for the current Accord. 23 However, capital requirements under Pillar 1 will most likely not be lower for several reasons: 1. For any risk category, supervisory authorities may choose to assign higher risk weights, in the case at hand, higher than 75% to microfinance (affecting the denominator of the capital adequacy equation). While the risk weighting for microloan portfolios could theoretically be lower than 100%, the supervisory estimates are mimima; these estimates were determined on the basis of experience in Basel Committee member countries. As noted above, national supervisors are called upon to assess the loss experience for a given type of exposure and adjust the risk-weighting of the exposure accordingly and to depend upon the domestic market practice and experience to determine the specific application. An important issue here is the perception of higher risk. While the track record of many microfinance portfolios is in fact strong, the microfinance sector needs to address continually the question of the actual track record as opposed to the perception of higher risk. The question of risk/vulnerability needs to be discussed on the basis of actual performance data. Financial institutions with microfinance portfolios need to argue continually for risk assessments to be based on an understanding of the specificity of microfinance and on actual portfolio track record. Supervisory authorities do not always adequately recognize that the management of the unsecured short-term portfolios of microfinance institutions wanting to integrate into the financial sector has to be strict. 2. As under the current Accord, regulatory authorities may stipulate a higher capital adequacy ratio for all institutions or for specific institutions, such as microfinance institutions (affecting the % itself); 3. A capital requirement for operational risk is a fundamental part of Basel II. The basic indicator approach calls for a capital charge as a function of gross income. This is important for MFIs as the reinforcement of internal processes and systems is important for the sound growth of the institutions and their integration into financial markets. 4. Market risk analysis can be used as a tool to see to what extent MFIs are really integrated into financial markets. Is the debt real? Is the equity real? Not to be underestimated is the importance of Pillars 2 and 3, designed to reinforce supervision and increase transparency. 22 The World Bank had expressed concern that the definition of retail and SME lending reflects standards prevailing in large industrial countries does not appropriately capture the risk features of smaller size firms in smaller countries. 23 See Annex 1 for a development of this point. 13

14 Pillar 2 covers the supervisory review process. Regulated institutions will need to acquire additional resources and/or upgrade the expertise of existing resources to implement the obligations under Pillar II, which is a comprehensive review of an institution s responsibilities under Pillar I, allowing supervisors to tweak regulatory capital levels. The principles of supervisory review are valid for all institutions (including those remaining with Basel I). Pillar 2 assumes competence and objectivity on the part of supervisors. With regard to microfinance, a good understanding of microfinance will be required. There is a need for a dynamic process of interaction between MFIs and supervisors. This is part of MFIs entering fully into the supervisory review process. Pillar 3. As stated above, market discipline is fostered by timely and reliable disclosure of a bank s financial information. Certainly, financial disclosure and transparency is considered a fundamental principle of building strong microfinance institutions. Placing increased emphasis on financial disclosure is an opportunity to improve systems internally and enhance the credibility of microfinance externally. This has been pushed in the microfinance industry for many years as a fundamental element of building the sector. Overall, accepting the objectives and principles behind the three Pillars is a sign of commitment. The means and timing of implementation can be worked out successfully only on the basis of informed dialogue among partners. Whatever the level of application, the cost of compliance and the administrative burden has to be taken into account. Whether under Basel I or Basel II, there are two factors which lead to higher levels of capital for MFIs, one on the regulatory front (regulatory capital) and the other market based (economic capital). 1. National supervisors will have considerable discretion to increase required capital above the 8% level indicated by the Accord, either by the risk weighting of assets or the designated capital ratio. (Note: Even if the legal minimum is 8% or 10% or 15%, supervisory authorities must have the ability to require higher capital levels if an individual institution s risk profile so warrants.) There is almost consistent evidence of increasing the capital adequacy ratio for microfinance. A study by Stefan Staschen for the Gesellschaft für Technische Zusammenarbeit 24 compares capital adequacy requirements imposed upon different forms of regulated microfinance institutions in 11 countries. In almost all the cases, the required capital adequacy ratio exceeded the 8% Basel level, reaching as high as 20% in the case of Micro Deposit Taking Institutions in 24 Regulatory Requirements for Microfinance: A Comparison of Legal Frameworks in 11 Countries Worldwide, by Stefan Staschen, for the Gesellschaft für Technische Zusammenarbeit, Postfach 5180, Eschborn, Germany Internet: 14

15 Uganda. Furthermore, market forces are likely to require MFIs to maintain capital well in excess of regulatory minimums in order for them to gain access to local market funding and other services. These influences offset some of the apparent benefits of the regulatory retail classification for MFIs in a decisive way. 2. Microfinance institutions are generally well capitalized, i.e. under-leveraged. On the basis of Women s World Banking s research on regulated microfinance institutions, 25 leverage remains relatively low, i.e. there is still considerable room for microfinance institutions to leverage their capital base to access bank funding and their local capital markets if conditions are favorable. In fact, at the same time, some transformed microfinance institutions seek to hold capital significantly in excess of regulatory requirements to send a signal of strength to the market. At the same time, overcapitalization may relate not only to MFIs deliberate goal of maintaining high capital levels, but to MFIs difficulty in leveraging up to their full potential because of the perceived risk by banks and other debt investors. In sum, MFIs capital levels could theoretically be lower than that based on a 100% risk categorization (75% based on the risk categorization for retail loans), they are unlikely to be so in practice because of: (1) supervisory practices to date and the perception of higher risk of MFis than larger financial institutions (unless MFIs actively help supervisors to assess the sector more objectively); (2) some MFIs actually deliberately elect to be more highly capitalized; and (3) the constraints on lending to MFIs by commercial bank lenders/investors that limit MFIs ability to fully leverage themselves Microloan Portfolios of Larger Bank and Non-bank Institutions The analysis of risk categories developed above would apply to microloan portfolios of other financial institutions, and thus a 75% risk weighting could theoretically lower the capital requirement for the microloan segment of the portfolio of a larger bank, if it were in fact applied. This would of course not be the case if supervisory authorities stipulated a higher risk weighting for the (uncollateralized) microloan portfolios. This is expected to be the case. It is unlikely that the microfinance portfolio of a larger institution will receive a lot of attention as supervisors implement Basel II, meaning the retention of the 100% risk weighting as under Basel I. Part 4. Microfinance Institutions as Borrowers in Capital Markets 25 Women s World Banking, Financial Intermediation and Integration of Regulated MFIs, October 2004 draft. 15

16 Part 3 focused on the impact of the proposed new Accords on regulated micro-finance institutions as lenders. What about its impact on them as borrowers? There are specific considerations for lending to banks. It is assumed that regulated microfinance institutions will be treated as banks under the New Accord. There are two options for the treatment of banks as borrowers. Option 1 is for banks which are not externally rated and Option 2 is for those which are externally rated. It is assumed that microfinance institutions are not (yet) externally rated by traditional rating agencies 26 and will treated under Option 1, which stipulates that all banks in a given country will be assigned a weight one category less favorable than the Sovereign Rating. A cap of 100% is imposed except for banks in countries rated less than B-, which have a cap of 150%. (The low income countries do not carry a Sovereign Rating, so the 100% cap would apply, thus not disadvantaging microfinance institutions as borrowers.) While this is theoretically the case, there has been considerable concern expressed that lending to developing country markets will decrease under Basel II. Much of the concern about Basel II relating to developing countries is that an increase in regulatory capital for internationally active banks will be due to lower rated borrowers, which are disproportionately represented in development countries. This would mean that the cost of borrowing would rise, due to an increase in regulatory capital in the lending institutions and the quantity of international bank lending would therefore go down. There has been considerable debate around this question. Further to this, the case has been made that the value of international diversification in terms of spreading risk in not taken adequately into consideration. So that the diversification of lending to institutions in developing countries should be a plus rather than a minus in terms of risk management; risk would be overstated without taking this diversification into account. 27 There is yet another concern and that is that capital markets will be more volatile, as there is an incentive to lend shorter term, at the short term loan category will be now only three months under Basel II, whereas it was twelve months under Basel I. This would lead to shorter term, and thus more volatile, lending. With regard to the borrowing of MFIs in capital markets, the evidence is not conclusive as to whether lending to MFIs will be less attractive under Basel II than Basel I. Part 5. Conclusions In conclusions, the impact of Basel II on microfinance institutions will come primarily from changes in the supervision culture overall, at the systems level and from a 26 MFIs are generally rated by specialized rating agencies, which do not come under the definition of raing agencies for the purposed of the Framework. This being said, there an increasing trend of MFIs accessing capital markets of acquiring external ratings from S&P, Moody s, Fitch. 27 See Stephany Griffith-Jones, Mistakes in Basel Accord Could Harm Developing Countries, IDS, Sussex. 16

17 possible increase in the cost of borrowing by microfinance institutions in international markets. The impact will come to a lesser extent from changes in the capital adequacy requirements for microfinance portfolios. 1. The impact of the new Basel Capital Accord depends in the first instance to the extent to which it is actually applied in developing countries and emerging market countries. There is initial evidence that many emerging market countries will not be applying the Basel II requirements at all or for all regulated financial institutions. While a large number of countries have said yes, country by country evidence suggests that the actual implementation and its timing will be very differentiated by country context. 2. Even in countries implementing Basel II, supervisory authorities will not apply the new Framework to all supervised financial institutions in their jurisdiction. In many countries, more progress in the application of the Basel Core Principles of Banking supervision is a pre-condition for the application of Basel II. Supervisory authorities are well advised to weigh the pluses and minuses of applying the new Framework. While Basel II has become synonymous with advanced banking supervision, it was never the intention of the Basel Committee for supervisory jurisdiction to apply Basel II prematurely. Basel II is based on the adoption of risk-based supervision, a change in thinking and procedures for both financial institutions and supervisory authorities in many countries. In terms of Pillar 2, there will undoubtedly be an evolution toward risk based supervision that will most likely affect all regulated financial institutions as this will involve a change in the basic premises of banking supervision. Supervision that reinforces the principle of better governed and managed will contribute ultimately to greater outreach of financial services, notably voluntary savings mobilization. It will also attract investors and increase integration into capital markets. 3. Where it is applied, the potentially positive impact, in terms of the more favorable treatment of retail portfolios, to which microfinance portfolios correspond, will probably not accrue to MFIs due to concerns about the risk profile of microfinance activities. Likewise, the microfinance portfolios of larger banks could theoretically require less capital than under the current Accord. Supervisory authorities have the right, expressed explicitly in the Framework, to apply risk weightings as they see fit, increasing the risk weighting for microfinance portfolios and are likely to do so. The greatest costs to MFIs may be not in terms of increased capital requirements, but rather in terms of the implementation costs of meeting the requirements of even the standardized approach under the Accord. Where Basel II is implemented, the administrative burden for both financial institutions and supervisory authorities will be significant, even for the simplest options. While investing in better risk management is a good thing for any financial institution, 17

18 the sophistication of implementation of Basel II may entail costs which are out of proportion to the degree of better management of the regulated MFIs. 4. Depending on their country of operation, MFIs might see their cost of funds increase due to the need for large and international lenders to MFIs to set aside additional capital overall under the New Accord. There is concern about access to capital by microfinance institutions (and other financial institutions and enterprises in developing countries) because of higher risk categorization for microfinance institutions as borrowers. In addition, there is concern that the application of Basel II will lead to reduced international capital inflows in emerging market countries overall. Analysts are in disagreement regarding the impact of Basel II on capital inflows in emerging market countries. 5. While criticized for its complexity, Basel II will be a force in improving supervision at the systems level and management of risk at the institutional level. There has been much emphasis placed on the mechanics of Basel II. There needs to be more emphasis on the exercise of prerogatives at the national leveling deciding how Basel II can be realistically implemented (or not), and on building supervisory capacity. This gives rise to the importance of building knowledge and awareness about the nature, and real risks, of microfinance as an asset class, to reduce bias against the sector. Supervisors and regulated institutions need to foster a climate of dialogue and improving skills levels, in the interest of building inclusive financial sectors; this includes a pragmatic and informed implementation of Basel II. The most significant developments to watch are: 1. The extent to which emerging market countries will indeed be applying Basel II and in what time frame. In other words, how national prerogatives are exercised. 2. The degree of readiness of supervisory authorities to apply Basel II, and, more fundamentally, to further implement the Core Principles of Banking Supervision; the introduction of risk based supervision by supervisory authorities. 3. Whether or not supervisory authorities will apply Basel II to microfinance institutions, even if they adopt Basel II for larger banks; where it is applied, administrative burden that microfinance and other financial institutions must assume. 4. The dialogue with supervisors regarding risk categorization of microloan portfolios; the ability of microfinance/sme finance to make the case for fair treatment. 18

19 5. Further analysis regarding impact of Basel II on financial markets in developing countries, both domestic markets and international capital flow, and more specifically, changes in the access to borrowing by microfinance institutions 6. If Basel II were to be applied to microfinance portfolios, testing the impact on capital requirements of MFIs. This can be done only when national implementation plans are determined. On final note, it is important to put the question of capital adequacy into perspective when it comes to microfinance. Capital adequacy is one element, albeit an important one, of prudential regulation. Regulated MFIs are generally well capitalized; there are in fact few cases of corrective action being required. MFIs generally have in fact other important concerns. Regulatory capital cannot substitute for good management and strong internal systems, whether for a regulated microfinance institution or a larger institution for which microfinance is one activity. 19