The BIS Regulatory Framework and Icelandic Banking Sector: Issues and Dilemmas

The BIS Regulatory Framework and Icelandic Banking Sector:Issues and Dilemmas Seminar at the Central Bank of Iceland February 18, 2002 Gudmundur Magnusson Saso Andonov

I. The Original (Old) Basle Accord (1988) – EU and EEA (1993) • Financial stability • Levelling of the competitive field • Minimum requirements • Standardization • Credit risk • Simplicity

II. The Basle Proposals for Market Risk – VAR (1993 and 1995) • Internal Value at Risk models; • Approval by supervisory authorities; • Trade off between CAR and VAR

III. The New Basle Accord – Proposals • Still more financial stability; • More differentiated measures of credit risk • Other types of risk (liquidity, operational, legal risk); • Supervisory review process; • More transparency; • Enhanced market discipline

IV. Points for Discussion: • Comparison of the New and the Old rules and potential implications of the new standards for credit risk; (a) Choice between two alternative approaches: the standardized approach (SA) and the internal ratings based approach (IRBA). SA – external credit assessment IRBA – own internal rating of borrowers (two options: foundation approach or own estimates) (b) Supervisors could require higher that the minimum capital target; (c) IRBA more risk sensitive; good for big banks, bad for small?

Price Structure of Credits With and Without Use of Credit Models

Proposals and Practice • Cost of capital versus risk-adjusted rate of return; • Credit risk models in practice; • VaR models, insurance-inspired models, Option-based models; • Acceptance by supervisory authorities

Points for Disscusion – cont. (d) More average capital needed as a cushion for macroeconomic fluctuations? (e) Small countries and small banks will suffer? (f) Manna from heaven for the rating agencies?

V. Comprehensive Risk Management on the Banking Industry Level • Comprehensive versus narrow scope of banking; • Investment banks and commercial banks; • New types of instruments; • Accounting standards; • Disintegration of banking; • Globalisation; • Lender of last resort; • Regulatory arbitrage

D.T. Llewellyn: Assessing the New Basle Capital Accord • Criteria for judging the effectiveness of any capital adequacy regime – the following twelve tests are suggested: • Does it have the effect of aligning the regulatory and economic capital? • Does it create incentives for effective and efficient risk analysis, management and control mechanisms; • Does it create appropriate incentives for the correct pricing of the risk? • Does it creates incentives for an efficient allocation of capital within the bank?

cont. • Does it create perverse incentives for regulatory arbitrage? • Does it create unwarranted entry barriers? • Are the capital requirements competitively neutral? • Are the requirements appropriate for overall portfolio risk, as opposed to the sum of project risks? • Does it have the effect of impairing competition in banking markets? • Does it have unfavourable effects on the macroeconomy; • Is the new Accord unnecessarily complicated? • Does it create or reinforce incentives for shareholders and other official supervisors to monitor the risks of banks and for market discipline to be exercised?

VI. CAR of the Icelandic Banking System:1989-2001

Second: the Alternative One • Financial Supervisory Authority of Iceland: • "The FSE has also declared that large Icelandic credit institutions, even showing an effective risk management and internal control, should at least aim for a minimum of a 10% CAD ratio. Other credit institutions should aim for a higher CAD ratio". Annual Report, 2000 • Central Bank of Iceland: • "The capital ratio of the financial institutions as a whole has been declining in recent years. At the end of 2000 it measured 9.9%, down from 10.6% the previous year. The commercial banks failed to reach their target of maintaining capital ratios of 10% and above last year". CB of Iceland Monetary Bulletin, Financial Stability, 2001, • International Monetary Fund: • "Decline in Icelandic banks’ CARs (both including and excluding subordinated loans), reflect the continued expansion of banks’ balance sheets without a corresponding increase in capital, as well as losses sustained on portfolio investments as a result of the emerging pressures in the domestic and foreign markets". IMF Iceland Financial System Stability Assessment;

Third: From an International Perspective Country 1997 1998 Denmark 11.61 11.32 Sweden 13.0 10.8 Norway 12.6 12.6 Iceland 9.8 9.1 Finland 11.9 11.5 USA 12.8 Japan 9.1 Israel 10.5

VII. Vulnerability and CAR in the Nordic Countries • Maintaining credible and prudent levels of CAR may provide an efficient mechanism in case of worsening macroeconomic conditions that may drive the system into banking crises: • It is a critical indicator of a disturbance of any nature in the bank operational environment and will ultimately be reflected in the changes of this ratio; • It can serve as an early warning signal; • Point for discussion: Would the banking crises in the Nordic countries in the early 90´s have been less adverse if agents had maintained higher than the minimum capital standards? • Is the CAR safe at any speed?

For Consideration: CAR in the Early 90’s • Lesson: Safety of the CAR depends both on its quality and nature of the environment

VIII. The Optimal Size of the CAR • In economic terms, regulatory capital should not be increased beyond the point where the marginal cost outweighs the expected marginal benefit from holding capital; • The most quoted criteria in determining the size of the CAR are: • Cost of raising capital; • Economic cycles and their importance for capital planning; • Size of the agent and its importance for the volatility of the income streams; • Access to liquidity including the Central Bank; • Credibility and peer group pressures;

Modelling the Optimality of CAR • In our opinion, optimality of the CAR should be derived from basic characteristics of the economy, both macroeconomic and microeconomic ones; • For that purpose, we are proposing four variables (or their proxies) to be taken into account when determining the desired capital ratio above the regulatory minimum; • The policy rule is based on the weighted differences or relative differences of the variables from matching peers (benchmarks);

Variable Candidates • Macroeconomic volatility measure: • Macroeconomic volatility - GDP real growth rate, price level, productivity, terms of trade; • Diversification measure: • Sectoral measures - such as loan concentrations ratios across sectors; • Overall portfolio measures - such as single exposure limits;

continuing • Microeconomic or banking sector-specific measure • Capital strength - such as the size and structure of the own capital; • Banking-sector specific volatility, such as bank deposits, bank credit to the private sector etc; • Profitability measure • Banking sector efficiency - measured through pre-tax profits as single measure or through weighted index of net interest income, non-interest income, operating expenses and the pre-tax profits.

Formally: Hypothesis + + ? ? • Where: • First term stands for macroeconomic volatility effect; • Second for diversification effect; • Third for microeconomic or banking sector-specific one; and • Fourth for bank profitability effect.

Exposition: • Theoretically dCAR=α(0.026-0.0098)= α0.0152 • where: 0.08 is the mandatory capital requirement; 0.26 is the standard deviation of the GDP of Iceland 1989-2000; 0.0098 is the standard deviation of the OECD countries GDP over the same period; • How to determine or calibrate α? • The value of the parameter α can be treated as adjustment parameter of the mandatory minimum and it can be derived using cross-country panel data estimates; • In a logarithmic multiple regression framework, α can be interpreted as an elasticity; • One can also impose additional restrictions to different parameters or group of parameters in order to determine their relative importance.

IX. Financial Stability Considerations • Two-front approach: • Accounting for structural vulnerabilities; • Improving risk management practices. • Structural vulnerabilities need to be located in the main sectors of the economy and assessment to be made as to how these can be met with corresponding buffers; • Concerning risk management practices, the optimal trade-off needs to be found concerning market induced vs. regulatory imposed risk management practices, both at the banking industry level and the individual firm level.

Structural Vulnerabilities and Buffers

Market-Based Predominant role of: Comprehensive risk management practices within the banks; VS. CAR, VAR, Credit Risk Modelling etc; Banks and MUST; Credit Rating Agencies Indications Transparency of market information and active shareholders; Mandatory rolling-over of certain part of sub loans on a secondary market. Regulation-Based Predominant role of: FSA power; Central Bank Regulations; Accounting and Risk Management Standards; Other government regulation; Market-Based vs. Regulatory-Imposed Risk Management Practices

The Early Experience of the Old Basle Capital Adequacy Framework: 1988

1992

1996

Model of Bank Behaviour Under Capital Regulation • Variable BIS is defined as: L - commercial loans; B - bonds; D - deposits; R - subordinated debts; K - capital; C(.) - cost function of BIS; r - interest rates;

Nominator vs. Denominator Changes of the CAR in G-10 Number of cases where changes in capital and risk-weighted assets contributed positively (+) or negatively (-) to the change in capital adequacy ratio

Areas of Impact of the Basle Capital Framework • Impact on Bank´s Balance Sheets: • Level of Capital Ratios; • Structure of Capital; • Risk-taking Behaviour; • Capital Arbitrage Effects; • Real Sector Effects: • Impact on Net Domestic Credit; • Impact on Output; • Impact on Long-Run Competitiveness of Banks: • Banks vs. Other Credit Institutions; • International Competitiveness Considerations

Contrasting Empirical Evidence • In adjusting their balance sheets, banks attempted to respond in the least costly way to binding capital constraints, depending on the cycle and the financial position; • Large and growing capital arbitrage may be motivated by other factors, such as taking advantages of economies of scale, better diversification of funding sources etc; • Changes in bank capital affect lending; • Money matters vs. lending matters for output growth; • Evident shift in the funding share by type of agents that can not be attributed solely to the capital regulation; • Cost of capital matters.

The Real Meaning of the Capital Adequacy Ratio • The Fundamental Rule: • Using the Basle model should not mean that the system is faithfully copied or not, but whether the appropriate adaptations were made to reflect local conditions; • Adaptations should be accounted for the risk environment • Ratio analysis should always be complemented by qualitative assessment of the bank´s ability to manage its risks;

Other Aspects Deserving Particular Attention: • Reliable market pricing of assets, particularly loan portfolio review and assets classification; • Collateral (re)valuation; • Loan loss provisioning and all that; • Interest income recognition policies; • Volatility and deepness of the markets of operation;

Iceland Commercial and Savings Banks: CAR and the Risk Profile

CAR, Macroeconomy and Banking Sector Indicators: Regression Results • Does CAR reflects the macroeconomic development and how macroeconomic shocks are accounted for? • The impact of CAR on bank lending: has Icelandic banking sector experienced credit crunch as a result of the imposed capital constraint; • Structural dimension of the CAR: which parts tend to add to the rise/fall in the CAR?

Variables Included • GDP - Real GDP growth rage, as proxy for the overall macroeconomic stance and the demand side of the bank lending; • BLEND - Annual rate of change in bank lending; • BDEP - Bank deposits as share of GDP; • GRSAV – Gross saving rate, annually, as supply side factor of the bank lending; • DISC – Discount Rate, as proxy for the supply side of the bank lending; • SUBL – Subordinated Loans; • TTRADE - Terms of trade, as proxy of the macroeconomic fluctuations; • DSHOCK - Dummy variable, having a value of 1 in the years when economy was hit by shock, and zero otherwise, as proxy for the shock performance;

Results • Dependent Variables: CAR (A1); BLEND (A2; A3) • Independent Variables:

Results Interpretations • Higher GDP growth rates and positive terms of trade have profound demand effects on lending causing increase in loans where excessively deteriorating macroeconomic conditions reduce credit; • Sign of discount rate is positive contrary to the theory where higher the discount rate the lower should be the rise in credits; • Increase in lending is accompanied by deteriorating capital adequacy ratios;

Cont. • On the other hand, capital ratio moves anticyclically w.r.t. the movement of GDP growth rate, while at the same time being negatively affected by the macroeconomic shocks; • Crucial issue is how banks are achieving higher or maintaining the desired level of the CAR by not reducing lending, for example? • CAR level is approached in a residual fashion by the changes in the other parts of the profit function.

Sub-Loans and Bank Capital

Iceland: CAR and Sub-Loans

The Impact of the New Basle Capital Adequacy Framework • Points for Discussion: • Size versus distribution of the CAR; • Procyclicality versus anticyclicality; • Banks behaviour versus CRAs behaviour;

Conclusion • CAR is becoming one of the main financial indicators along with the prevailing market conditions that always require certain margin over the minimum; • If banks should set more capital aside as the risk increases, how can one prevent sharp portfolio reallocations in times of stress? • CRA´s behaviour will be crucial for the financial stability.

The BIS Regulatory Framework and Icelandic Banking Sector: Issues and Dilemmas