Transcript Document 7371768
From Basel I to Basel II: Implications and Challenges for Emerging Markets
Liliana Rojas-Suarez
Main Messages
1. The effectiveness of the Basel Capital Accord in emerging markets depends on countries’ degree of financial development, which varies significantly across this category of countries.
2. Effective banking supervision in emerging markets needs to take into account particular features of these economies that are different from those in industrial countries. This implies the implementation of
additional
policies to complement Basel and, sometimes, even
transitional
policies
before
fully implementing Basel.
Background: Capital Requirements Have Not Always Constrained Risk-Taking Behavior of Banks in Many Emerging Markets
Real Net Equity Growth in Selected Banking Systems at the Eve of a Crisis* (in percent)
50 40 30 20 10 0 -10 N orw ay 1 99 1 Sw ed en 1 99 1 Ja pa n 19 94 U SA N on cri si s: 1 99 4 Arg en tin a 19 93 M al ay si a 19 96 Th ai la nd 1 99 6 M ex ic o 19 93 Ec ua do r 1 99 5 In contrast to industrial countries where net real equity decreased before the eruption of a crisis, net real equity growth reached very high levels in the eve of severe banking crises in emerging markets…
Background: Capital Requirements Have Not Always Constrained Risk-Taking Behavior of Banks in Many Emerging Markets
Accuracy of Indicators in Predicting Banking Problems (%) Countries Mexico Venezuela Colombia Thailand Korea
(1993-94) (1993-94) (1981-88) (1996-97) (1996-97) Accuracy in predicting bank problems (%)
Traditional Indicators:
Capitalization Change in equity prices
7
37
31
n.a.
14
25
30 Meaningless (100)
n.a.
n.a.
Malaysia
(1996-97)
37
n.a.
Net profits to income 60 13 43 60 60 50 Operating costs to assets Liquidity ratio 40 7 13 13 29 29 20 50 20 56
Memo Item:
Interest rate on deposits
80 69 71 66 80
…and capitalization ratios have performed very poorly as early-warning signals of banking crises.
25 60
62
Background: Capital Requirements Have Not Always Constrained Risk-Taking Behavior of Banks in Many Emerging Markets The Reason: For capital requirements to work as effective indicators of bank strength two sets of conditions must be met: I.
II.
The well-known condition related to the appropriate accounting, regulatory, supervisory and judicial frameworks.
Capital requirements need to reflect the “true risk” of a bank’s portfolio.
A Policy Issue for Supervisors in Emerging Markets : Has the Basel Accord been Appropriate for these economies?
The short answer is: Implementation of Basel I has not achieved its intended goal of strengthening banks in Emerging Markets as the Accord does not reflect the specific risk characteristics of asset portfolios in Emerging Markets.
How the “Application” of Basel may weaken banking systems in Emerging Markets
Example 1: Treatment of Bank Credit to the Government Its application has distorted the intention of the Accord by the preferential treatment of bank credit to the government. This encourages banks to hold government paper at the expense of private sector loans.
Claims on central and noncentral government as a percentage of total assets of deposit money banks 1980s against 1990s
70.0
POL 60.0
50.0
40.0
ISR BRA 30.0
PERU 20.0
10.0
0.0
0.0
THAI MAL KOR CHI SING ECU COL 10.0
PHI VEN HUN INDONESIA 20.0
ARG MEX INDIA TURK 30.0
40.0
average value 1990-2000
50.0
60.0
70.0
How the “Application” of Basel may weaken banking systems in Emerging Markets
Example 1: Treatment of Bank Credit to the Government 5.0
20.0
0.0
0.0
-20.0
1997
Economic Activity and Banks' Claims on Government as Percentage of Total Assets
Total claims on government as percentage of total assets of deposit money banks GDP Growth Rate 100.0
0.0
-100.0
1997 1998 1999 2000 1998 1998 1999 2000 2000
Turkey
35.00
60.00
30.00
50.00
25.00
40.00
20.00
30.00
15.00
20.00
10.00
10.00
5.00
0.00
-5.00
1997 1998 1999 2000 2001 0.00
-10.00
1997 1998 1999 2000 2001 -20.00
-10.00
Source: IMF (2002)
International Financial Statistics
; World Bank (2001)
World Development Indicators
and private sector forecasts.
The regulatory treatment of government paper contributes to exacerbate recessions.
How the “Application” of Basel may weaken banking systems in Emerging Markets
Example 1: Treatment of Bank Credit to the Government EMBI Spread and Claims on Government as Percentage of total assets of deposit money banks
Argentina
32 30 28 26 24 22 20 Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Claims on government EMBI Spread 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0
Turkey
60 55 50 45 40 35 30 25 20 Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Claims on government EMBI Spread 1200 1000 800 600 400 200 0 Banks continue to increase their relative holdings of government paper even if the market signals increased “riskiness” for these assets. This weakens the quality of banks’ assets.
Example 2: Rules on Interbank Lending
Consolidated Cross-Border Claims of BIS Reporting Banks
Claims on: Argentina Bolivia Brazil Chile Colombia Ecuador Mexico Peru Venezuela China Hong Kong India Indonesia Israel Malaysia Philippines Singapore South Africa South Korea Taiwan Thailand Bulgaria Croatia Czech Republic Hungary Poland Russia Slovak Republic Turkey Total Reported 60,981 1,281 72,401 20,373 11,193 1,322 73,659 12,838 12,127 54,454 106,341 19,079 36,468 8,785 20,327 15,719 94,170 18,882 54,057 15,439 23,856 1,543 7,368 8,488 18,360 25,464 38,565 4,159 37,585 O/W with maturity of one year or less 33,007 819 35,185 8,543 3,966 802 28,860 8,061 3,692 21,808 69,571 7,488 18,169 4,046 6,882 5,803 63,812 10,564 31,981 10,436 9,451 526 2,199 4,290 5,563 11,280 12,859 1,927 21,414 Percent of Total
54.1% 63.9%
48.6% 41.9% 35.4%
60.7%
39.2%
62.8%
30.4% 40.0%
65.4%
39.2% 49.8% 46.1% 33.9% 36.9%
67.8% 55.9% 59.2% 67.6%
39.6% 34.1% 29.8%
50.5%
30.3% 44.3% 33.3% 46.3%
57.0%
All figures in mil USD. Reported as of end of September 2001
Basel’s treatment of interbank lending to non-OECD countries has reduced the maturity of loans to emerging markets.
Example 2: Rules on Interbank Lending The combination of Basel’s treatment of interbank lending with domestic regulation in emerging markets aiming at controlling the maturity mismatch between assets and liabilities provides an incentive to shorten the marginal maturity of domestic loans and increase the fragility of the banking system.
What About the Proposed New Accord (Basel II)?
While the implementation of Basel II may be a powerful tool to strengthen banks in Emerging Markets, it could also exacerbate weaknesses and increase the fragility of banking systems. Appropriately adapting the Accord to the risk features of emerging markets as well as designing complementary policies is essential to derive benefits from the international capital standards.
Challenges from Supervisors in Emerging Markets derived from Basel II
A.
External “Potentially Adverse” Effects (uncontrolled by Emerging Markets)
I.
Implementation of Basel II by industrial countries may exacerbate the already high volatility of capital flows to emerging markets:
rating a. If banks in industrial countries use the internal based approach it may be easy to “game” the rules and there is a risk of a potential weakening of supervisory practices. If an underestimated markets quickly manage capital (overestimated) risk to emerging materializes, international banks will reverse (increase) the flows to micro requirements.
Challenges from Supervisors in Emerging Markets derived from Basel II
External “Potentially Adverse” Effects (uncontrolled by Emerging Markets)
I.
Implementation of Basel II by industrial countries may exacerbate the already high volatility of capital flows to emerging markets:
b. If banks in industrial countries apply the Standardized approach, volatility of capital flows to emerging markets also gets exacerbated as: - Credit rating agencies have a track record of lowering ratings AFTER the eruption of problems in emerging markets.
- De facto, sovereign ratings constitute a ceiling for ratings to the private sector.
Challenges from Supervisors in Emerging Markets derived from Basel II
External “Potentially Adverse” Effects (uncontrolled by Emerging Markets)
II.
Implementation of Basel II by industrial countries may contribute to shorten the maturity of emerging markets’ external debt:
Basel II lowers the maturity of inter-bank loans subject to lower capital charges (preferential treatment). This implies that international banks will have an incentive to shorten the maturities of loans to emerging markets. This adversely affects current efforts of emerging markets to extend the maturity structure of foreign liabilities. \
Challenges from Supervisors in Emerging Markets derived from Basel II
•
B.
Internal Effects (Created if Emerging Markets Adopt Basel II)
-
I. Issues Related to the Measurement of Risk
A potential advantage is that banks’ risk of holding government paper could be determined by market conditions. However, an “opt-out” clause allows countries not to follow this recommendation. Will governments be prepared to let the markets assess the risk of their liabilities for the purpose of computing banks’ capital ratios? If Basel II is implemented, most small and medium companies in emerging markets will not be subject of credit (capital charges would be too high). This is an important issue for governments in these countries.
Challenges from Supervisors in Emerging Markets derived from Basel II
Internal Effects (Created if Emerging Markets Adopt Basel II) II. Supervisory Issues
- While few domestic banks are in a position to use the internal rating-based approach (IRB), there could be a number of foreign banks allowed by their industrial-country supervisors to follow the IRB approach. Lacking sufficient supervisory training in many emerging markets, would domestic supervisors rely on foreign supervisors? The issue of “home” vs. “host” supervision becomes relevant.
- With the standardized approach, the use of credit rating agencies may “bias” ratings of borrowers who have the incentive to “hire” the agency that offers the best rating: the ‘race to the bottom” problem.
Challenges from Supervisors in Emerging Markets derived from Basel II
Internal Effects (Created if Emerging Markets Adopt Basel II) II. Supervisory Issues
- With the standardized approach, most companies will remain “unrated” and with a 100% risk-weight. There is also an incentive for weak companies not to be rated (because if these companies choose to be rated they will be subject to a 150% risk weigh).
- There is no appropriate regulatory framework for credit rating agencies in emerging markets.
Policy Recommendations for Emerging Markets
Basic weakness in regulatory and supervisory framework need to be addressed Accord.
before
implementing the new In the
Transition
towards the New Accord, design a standard that appropriately reflects the risks of banks’ assets. That is, modify current capital requirements to: – – Initiate risk-based regulations in loan loss provisions Maintain a simple classification of assets according to risk but drastically modify the risk categories.
Two examples: – Appropriate risk assessment of government paper.
– Credit risk distinction between borrowers from tradable and non-tradable sectors.
Policy Recommendations for Emerging Markets
Enhance the mechanisms of market discipline
. Lacking deep capital markets to guide supervisors about the “true” value of reported capital, information about the quality of banks’ assets can be obtained through: – Encouraging the offering of uninsured certificate of deposits.
– Developing credit bureaus.
– Encouraging the development of the inter-bank market.
Encourage the participation of foreign institutional investors
.