Outline of the presentation

1. Bank Capital and Loan Loss Reserves under Basel II:Implications for Latin America and Caribbean Countries.Giovanni MajnoniRisk Management Workshop: From Theory to ImplementationCartagena, ColombiaFebruary 19, 2004

2. Outline of the presentation • Objective of the paper. • A simple meter for credit risk. • A regulatory strategy for countries that are not ready to adopt the IRB but would like to introduce risk based solvency ratios.

3. Objective of the paper (1) • Provide an integrated regulatory framework for bank capital and loan loss reserves (LLR). • Only in October 2003 the Basel Committee (BC) has recognized LLR as an integral component of capital regulation… • … but only for banks that will opt for the IRB approach, therefore leaving this option out of reach for most banks in the developing world.

4. Objective of the paper (2) • The World Bank has consistently advocated that solvency ratios are meaningless – in fact they are deceptive - if they are not matched by adequate loan loss reserves. • What matters is the total Value at Risk (VaR) which is not directly observable … • ... but supervisors need to measure rapidly and unambiguously… • … to define any remedial action.

5. A simple meter for credit risk (1) • In line with our objective our first step has been that of devising a conveniently simple measure of VaR… • …something that could be for credit risk what • thermometers or barometers are for the body temperature or for the atmospheric pressure.

6. A simple meter for credit risk (2) • Thermometers or a barometers allow: • to detect promptly and with no error the presence of perceivable but not observable problems but… • do not provide a diagnosis of the causes of the detected distress.

7. A simple meter for credit risk (3) • As a result of the proliferation of credit risk models in recent years we have now many diagnostic tools of credit risk but… • we lack simple measures of credit risk exposures that allow us to take the temperature of the system.

8. A simple meter for credit risk (4) • Credit risk exposures are derived from underlying models … • …but models are simplified representations of reality and may impose unwarranted restrictions on reality (model error)… • … or may rest on unobservable parameters that can be approximated only with errors (measurement error).

9. A simple meter for credit risk (5) • All we need for the discussion on capital requirements is: • A measure of the VaR for the banking system; • A criteria for splitting VaR among Capital and LLR. • Metaphorically: we need to be able to measure the fever in the credit system independently from its causes.

10. A simple meter for credit risk (6) • Carey (2002) has suggested a solution showing that: • the distribution of credit risk (with EL and UL) can be measured without identifying risk factor loadings, volatilities, correlation; • but taking them fully into account. • How? • The answer is a statistical procedure called “bootstrapping”.

11. The re-sampling method (1) • Step 1: extract from the CR all the loans at the beginning of a predefined period. • In Argentina 70017 positions in December 2001

12. The re-sampling method (2) • Step 2: random draw of 500 loans for 20,000 times. • In Argentina the median value is US$ 215 millions

13. The re-sampling method (3) • Step 3: find the loans that defaulted over 1 year and compute the losses for the 20,000 portfolios. • In Argentina the EL=4.8% and the UL(99%) =14.8%

14. The re-sampling method (4) • A snapshot of the distribution of credit losses in the year 2001 in Mexico, Argentina and Brazil. • Re-sampling UL and Basel UL

15. The re-sampling method (5) • Preliminary conclusions: • The procedure is extremely simple yet able to measure all the variables (VaR, K, LLR). • The IRB formula, applied to a sample of non-G10 countries, generates levels of protection inferior to the claimed 99.9%. • Solvency ratios compatible with a 99.9% could be prohibitively high (unless LLR>EL); • An 8% capital ratio in the SA (EL+UL) offers an protection level in the range of 95% (unless LLR>EL).

16. The re-sampling method (6) • The statistical evidence suggests some policy issues: • National supervisors under Pillar 2 will have to monitor the level of protection of their solvency rules (to apply Basel formulas is not enough). • Protection can be offered by K or by LLR and the choice may be dictated by prevailing legal and regulatory constraints. • The required integration of K and LLR may not be easy for countries that have no choice but to adopt the Standardized Approach (SA).

17. A Regulatory Strategy (1) • To address the previous questions a regulatory strategy should: • introduce simple elements of a risk based capital regulation also where basic Basel II approaches (SSA, SA) are chosen. • encourage banks to evaluate of their customer solvency (PDs) more than capital requirements. • alleviate the resource constraints faced by bank supervisors reducing the monitoring costs of capital regulation.

18. A Regulatory Strategy (2) • These criteria we believe are fulfilled by the Centralized Risk Based (CRB) approach: • A loan classification set centrally and in line with Basel II criteria (at least 9 grades) and with definition of default; • Loan categories defined by the upper and lower level of PDs; • Level of capital and provisions set centrally for each bucket or grade based on the average or median PD for each bucket.

19. A Regulatory Strategy (3) • Main advantages of the CRB: • A centralized loan classification scale saves banks the cost of defining their own internal classification standard while still requiring a PDs evaluation. • A common scale lowers monitoring costs for bank supervisors (easier comparisons across banks and back-testing). • Risk management improves independently from the adoption of Basel II or IRB.

20. A Regulatory Strategy (4) • Main advantages of the CRB (continued) • The system would ensure a consistent treatment of capital and loan loss reserves. This is of course a vital component of Pillar 2 and Basel Core Principle 8. • Individual banks data could be aggregated at a country level generating an important, so far mostly missing, information about the cyclical developments of credit quality.

21. A Regulatory Strategy (5) • How the CRB would work in the SA: • For countries that face legal and regulatory restrictions in adjusting the amount of capital from the minimum general level (8% or higher) LLR would be adjusted to achieve the desired level of protection (99%, 99.9%). • For countries that cannot adjust the level of LLR capital should be modulated to complement the existing level of LLR at the level of each individual grade.

22. Conclusions (1) The SA or IRB approach should not represent a dilemma for emerging economies. This paper suggest the following steps as a way out: 1. Find an effective measure of a banking system exposure to credit risk (VaR) and select an appropriate level of security; 2. Emerging economies cannot rely for step 1 on BCBS calibrations;

23. Conclusions (2) 3. A centralized loan classification device should be adopted that is based on PDs and that provides EL and UL for each loan grade. 4. The appropriate combination of capital and LLR rests on the specific legal and regulatory constraints of each country.