International Banking Standards and Recent Financial Reforms Mark M. Spiegel Vice President International Research Federal Reserve Bank of San Francisco Prepared for conference on Capital Flows and Global External Imbalances April 2006, Paris. Views expressed are my own and do not necessarily reflect those of the Federal Reserve System
Outline I. International Regulatory Standards (Basel II) II. Policy Issues III. Basel II for Emerging Economies IV. Other Financial Reforms
I. International Regulatory Standards (Basel II)
New Basel Proposal Implementation expected to available end-2006 Advanced IRB to be available end 2007 Simultaneous operation of Basel I and Basel II until 2008 Floor Basel I minus 15% United States pursuing a somewhat different course Implementing only advanced IRB Only mandatory for most advanced banks Other authorities can proceed at their own pace
Accord based on three pillars Minimum capital requirements Supervisory review Market discipline
Pillar 1: Minimum Capital Requirements Capital requirements will have greater flexibility and reflect bank risk Some banks will be allowed to assess risk internally, subject to approval There will be an explicit capital charge for operational risk Risk unassociated with intrinsic asset values Expected to comprise 20% of requirement Overall regulatory capital is not expected to change, but may increase or decrease for individual banks
Approaches for Assessing Credit Risk Simplified Standardized Approach Standardized Approach Foundation Internal Ratings Based (IRB) Advanced IRB
Simplified Standardized Approach Closest to Basel I Some minor modifications Use Export Credit Agency ratings to calculate required capital for sovereign risk exposure Available on OECD web site Corporate capital still at 8% Capital requirement for operational risk Uses Basic indicator approach 15% of gross annual operating income Other modest changes (lending to sovereign in own vs. foreign currency)
Standardized Approach for Credit Risk Assessment Banks allocate their exposures to risk buckets defined by regulators Risk weights depend on borrower identity Two methods of assigning risk weights One category below rating of headquarter country External risk weighting of institution Risk mitigating factors also incorporated
Risk Weights Under Standardized Approach AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Claims on Sovereigns 0% 20% 50% 100% 150% 100% Claims on Banks Option 1 (rating refers to sovereign) 20% 50% 100% 100% 150% 100% Claims on Banks Option 2 (rating refers to bank) 20% 50% 50% 100% 150% 50%
Issues with standardized approach Because of low penetration of credit rating agencies, most claims would be risk-weighted at 100% Same as Basel I Rated firms tend to be least risky To be rated, probably have issued debt Means no real change for riskiest firms These unrated firms are usually bulk of system in EME s
IRB Approaches to Credit Risk Assessment Foundation-based approach Banks can use their own estimates of loan default probabilities Probabilities are combined with standard estimated of losses given default to determine value-at at-risk Advanced approach Banks estimate value-at at-risk as well Limited to most sophisticated banks
Regulatory Impact Overall capital requirements expected to be unchanged on average Calibrated to Standard loan 1% default probability, 2.5 years maturity, 45% loss given default 8% capital requirement Capital requirements will be increasing in credit risk assessments Capital Requirements will also be adjusted for credit risk concentration Excessive exposure to a single borrower subject to additional capital requirement Exceptionally low exposure can lead to reduction at discretion of domestic regulator
Numerical Example $10 billion loan Basel I: Capital Requirement $800 million Basel II: Healthy loan: Capital Requirement $100 million Bad loan: Capital Requirement $4.5 billion Bottom Line: Extensive sensitivity to credit risk under new program
Operational Risk Basel II also includes a capital requirement for operational risk On average, will offset reduced requirement on rated loans under standardized approach But may not be offset for EMEs with many unrated firms Operational Risk also has three approaches Basic Indicator Standardized Advanced Measurement
Operational Risk (OR) Also tiered to allow some self-assessment Basic indicator: OR=0.15*Gross Income Standardized: OR also proportional to gross income, but weights different across different business lines Advanced Measurement: Banks use own methods for self- assessment of OR exposure Can incorporate insurance implications Agreed that initially not as precise as credit risk Fontnouvelle,, et al (2003): many banks underestimate OR exposure
Pillar 2: Supervisory Review Committee confirmed the need for supervisory review in addition to minimum capital requirements Supervisors will determine soundness of internal processes used to assess capital adequacy and bank risk Intervention under conditions where violations are found
Four key principles Banks are responsible for assessing capital adequacy Supervisors role in assessing internal monitoring of bank Banks are normally expected to operate with capital above regulatory minimum Supervisors should intervene into problem banks at an early stage
Compliance with Basic Core Principles is still Limited in Developing Countries Source: Powell (2004)
Pillar 3: Market Discipline Disclosure is necessary for market participants to assess the risk profile and capital adequacy of banks Proposals provide guidance on disclosure Capital structure Risk Exposure Control Environment Bailing in of private sector
II. Policy Issues
Procyclicality One objection to Basel II framework is that risk- based bank capital positions will be artificially pro-cyclical Asset value movements are pro-cyclical Committee has expressed concern, but so far only gave guidance that IRB assessments should be sufficiently conservative Difficult to say that market prices are wrong
Small and Medium Enterprises (SMEs) Banks will face a lower capital requirement against SMEs than against large firms Average reduction across SME borrowers will be 10 percent SME lending also exempt from strict mark- to-market restrictions
Treatment of Expected vs. Unexpected Losses IRB measurement of risk-weighted assets for capital requirement to treat expected and unexpected losses differently Risk-weighted requirements solely on unexpected portion Expected losses not covered by provisions are treated as shortfalls 50 percent deducted from tier-1 1 capital 50 percent deducted from tier-2 2 capital More in line with current U.S. policy
Initial participation by developed nations Europe and Japan will begin with symmetric Basel I and Basel II U.S. Banks either remain under Basel I or move immediately to advanced IRB Issue now with Congress Looks like top 10 U.S. banks to move to advanced IRB
III. Basel II For emerging economies
Basel II Created by Basel Committee for Banking Supervison G10+ nations Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, U.K., U.S. This leaves 170 non-g10+ countries (primarily emerging economies) wondering about implications of Basel Quantitative impact studies have concentrated on G10 and OFCs Little formal work on impact on EMEs
Are emerging economies ready? 50% of countries only compliant with 10 or fewer of the 30 Basel Core Principles (BCP) of effective banking supervision 1/3 of nations compliant with five or fewer Average developing country compliant with 7 BCPs average DC compliant with 19
Compliance with Basic Core Principles much more Limited Among EMEs Source: Powell (2004)
Reasons to be skeptical about desirability of SSA for EMEs Main impact expected to be capital levy for operational risk, expected to increase capital requirements on average Will punish EME s for having lower share of rated firms Use of export agency ratings doesn t t closely tie true risk exposure in lending to sovereigns to risk Reduces minimum capital requirements on mortgages Response to increased mortgage lending safety in DCs Unclear that these loans are safer in EMEs Also reduces capital requirements on retail May be inappropriate to EME environments where systemic risk is high
Basel II Decision Tree for EMEs Compliance with Pillars I and II and monitor operational risk? No Yes Basel I Feasible/Desirable to Increase Capital Requirement? No Basel I Yes Rating Generation? Low Reasonable Better Basel II-a Pillar I: Simplified Standardized Approach Basel II-b Pillar I: Standardized Approach BCP Compliance? Good Very good Centralized Rating Transition to IRB IRB
Impact on DC bank lending to EMEs Some concern that because developing country debt is speculative grade, Basel II will decrease lending to LDCs Capital charges to lending banks will be higher But link between loan pricing and regulatory capital is limited
New Basel Eliminates Long-term lending capital requirement Current accord charges 8% for loans to foreign banks exceeding 1 year Only 1.6% for shorter-term term claims Thought to encourage short-term term lending that exacerbated Asian currency crisis New Accord also likely to introduce heterogeneity among EMEs Near investment grade EMEs (Chile, Malaysia) likely to see interest rate declines Lower grade will increase However, even for these countries interest rate increases are expected to be modest [Hayes and Saporta (2002)]
IV. Other Financial Reforms
National Policies have greatest impact on Finnacial Environment Limit financial safety net Deposit insurance Lender of last resort activity Strengthen Regulation and Supervision of Banking System Strengthen regulatory regime Enhance capital standards Opening up to Foreign Banks Macro policies
Limits to deposit insurance Deposit insurance removes incentive for panic runs on banks However, deposit insurance also creates moral hazard by removing incentives of depositors to engage in monitoring activities Explicit vs implicit deposit insurance Explicit guarantees against idiosyncratic and systemic losses Implicit may only guarantee against systemic losses
Deposit Insurance Reforms Limits to explicit deposit insurance Coinsurance: : In event of a bank failure, depositors lose a specified fraction of the overall loss Italy: Tied to deposit levels Risk-Adjusted premia Both these reforms have effect of bailing in the private sector, and thereby mitigate moral hazard Demirgüç üç-kunt and Detragiache: : Reducing Deposit insurance coverage reduces probability of banking crises
Avoid Excessive Lender of Last Resort (LLR) Activity Inflation expectations Increased money supply leads to expectations of future inflation and further depreciation Local nominal interest rates therefore increase Currency depreciation Many developing countries have short-term term debt denominated in foreign currency LLR activity can depreciate currency and weakening firm and bank balance sheets
Strengthening Regulatory System Regulatory agencies need adequate resources Proper accounting practices must be enforced Prompt corrective action must be taken to enforce rules Independence of regulators
Opening Up to Foreign Banks Benefits Increased efficiency Relatively insulated from government Greater ability to weather crises Better financed Better management Ex: Argentina: 50% foreign-owned, owned, weathered Asian crisis Costs: Dollarized liabilities Ex: Argentina
Price Stability Allows Intermediation with longer-term contracts Allows borrowing denominated in domestic currency Allows policy makers to respond to domestic liquidity problems without triggering inflation fears
Perils of Fixed Exchange Rates Encourage exchange risk exposure No substitute for domestic sound fiscal and monetary policy Discrete jumps lead to crises Currency mismatch issues were paramount in recent Argentine crisis
Conclusion Challenge in international financial regulation is to strike a proper balance between allowing markets to function and mitigating risk of crises On international level, Basel II provides opportunities and challenges for EMEs But most novel aspects of Basel II are unattainable for EMEs Could make major strides by formally adopting Pillars 2 and 3 However, national policies are still paramount for EMEs