Basel II and Monetary Policy in Small Open Economies

1. Basel II and Monetary Policy in Small Open Economies Ásgeir Jónsson Jón Daníelsson May 2005

2. The outline • Basel II and Procyclicality • Basel II and Monetary Policy • Currency dependence • The exchange rate externality • Monetary policy in currency dependent economies. • Proposals

3. Basel II and pro-cyclicality

4. Basel II and Pro-cyclicality • One of the central changes proposed by the new Basel II regulatory framework is the concept of internal-rating-based (IRB) capital requirements. • Under the IRB approach, regulatory capital will be a function of the estimated credit risk. • Estimated credit risk is taken to be a predetermined function of four parameters: probability of default (PD), loss given default, exposure at default, and maturity. • Banks operating under the “Advanced” variant of the IRB approach will be responsible for providing all four of these parameters, based on their own internal models. • Banks operating under the “Foundation” variant of the IRB approach will be responsible only for providing the PD parameter, with the other three parameters to be set externally by the Basel committee.

5. Basel II and Procyclicality • Most discussions of bank capital regulation start from the premise of keeping the probability of bank default below some fixed target level. • It is common to speak of, say, a 99.90 percent confidence level, which means that the bank has only a 0.10 percent probability of default over the next year. • Once this target level is set, one can use information on the bank’s portfolio—along with various other assumptions—to figure out how much capital it will take to achieve the target. See e.g. Gordy (2003). • This Basel II approach can be summarized in terms of a single “risk curve,” which relates the capital charge for any given loan to the risk attributes of that loan, such as its probability of default.

6. Basel II and capital charges

7. Basel II and Pro-cyclicality • However, in a downturn the banks' capital base is likely being eroded by loan losses. • Its existing (non-defaulted) borrowers will be downgraded by the relevant credit-risk models, forcing the bank to hold more capital against its current loan portfolio. • It is invariably difficult or costly for banks to raise fresh external capital in bad times, which will force them to cut back on its lending activity, thereby contributing to a worsening of the initial downturn. • Thus, the new Basel II regulatory framework is likely to have pro-cyclical effects which can lead to over-lending in booms and underinvestment during recessions.

8. Basel II and Procyclicality • As with any form of regulation, the case for regulating bank capital presumably rests on some sort of market failure, or externality. • In this case, the externality is that bank failures have systemic costs that are not fully borne by the bank in question. • These systemic costs include losses absorbed by government deposit insurance, disruptions to other players in the financial system etc.. • Thus, the regulator’s task is to somehow get the bank to internalize these systemic costs. • However, a social planner might not only think about bank defaults per se. • She should also think about the efficiency of bank lending, that loans with a positive net present value are still to be made in recession.

9. Application to the small open economy • If currency risk is properly hedged or measured Basel-II should be no more pro-cyclical for small open economies than in the big currency areas • However, even though banks' foreign currency assets and liabilities match in amounts and maturities it does not mean that the currency risk has been hedged. • Movements in the exchange rate have a direct effect on the burden of debt of currency linked loans and are a thus a major factor for credit risk assessment. • Since movements in the exchange rate are pro-cyclical, the application of Basel II with regard to credit risk is likely to be more pro-cyclical in small open economies carrying currency linked debt.

10. Application to the small open economy • How should currency risk be estimated? • Measurement of Market Risk in Basel-I and II is based on Value–at–Risk (VaR) methods • One year of historical data (in most cases) • Usually from conditional normal volatility • Exchange rates usually have low volatility • Central Bank may even stabilize exchange rates, thus further lowering volatility, but not risk • But does VaR capture extreme changes in the exchange rate?

11. Mexican Peso/USD Returns

12. Basel II and Monetary Policy

13. Basel II and monetary policy • The consensus is slowly emerging that Basel capital adequacy rules (both I and II) can have substantial effect on the transmission of monetary policy. • This is due to the failure of the Miller-Modigliani theorem for banks, the banks' lending decisions are not independent of their financial structure. • Two channels • The lending channel • The Bank Capital channel • For early work on "Credit Crunch" associated with Basel I, see Bernanke and Lowe (2002).

14. The Bank lending channel • The banks cannot expand lending without an corresponding equity to comply with the capital adequacy requirements. • New equity cannot be issued during downturns and the CAD constraints can become increasingly binding for new loans. • At the extreme, the capital constraints become binding (e.g. At the 8% target level) and the lending channel shuts down. • This has been named "virtual liquidy trap" see Jónsson and Daníelsson (2004) • There is no inter-bank market for bank equity and therefore it is not only the average capital that matters but also its distribution among the banks.

15. The Bank Capital channel • In reality, most banks are not at the capital constraint at any given time. However, the risk of breaching the constraint is very real. • Van den Heuvel (2001, 2002) has shown in a model calibrated with U.S. data that a low-capital bank may optimally forgo profitable lending opportunities in order to lower the risk of future capital inadequacy. • The level of bank capital may thus have a substantial effect on the transmission of monetary policy. • A tighter monetary policy and higher interest rates will reduce future profits of the banks, however the effect on lending will be dependent on the capitalization of the banking system.

16. The exchange rate externality

17. Currency Dependence • About 98% of international bond issues are in just 5 currencies (Euro, Dollar, Pound, Yen and Swiss Franc) • Countries outside these currency areas, needing to draw international funds, have to borrow in foreign currency. • This applies to Less Developed Economies, New Market Economies, Emerging Market Economies, as well as developed small open economies. • In these countries, domestic residents hold foreign or currency linked debt, usually obtained through the domestic banking system. • We term this as currency dependence

18. Related concepts • Liability dollarization and Debt Intolerance • Applies to the pre-dominance of foreign debt in emerging market economies and the inability handle the overall debt which would seem quite manageable by the standard of developed economies. See Reinhart, Rogoff and Savastano (2003) • Original Sin • Applies to the inability of a country to borrow abroad in domestic currency, causes of which has argued to be "secondary market liquidity premium in currency markets. See Eichengreen, Hausman and Panizza (2003). • Currency mismatches • Applies to the "sensitivity of net worth or of the present value of net income to changes in the exchange rate" increasing the cost of crisis in the event of a large depreciation of the currency. See e.g. Goldstein and Turner (2004)

19. The Exchange rate externality • In currency dependent economies, foreign currency lending on the behalf of domestic banks improves the capital margin of other banks, including banks who do not engage in foreign currency lending • The inflow of foreign currency and appreciating exchange rate causes the value of assets and foreign debt denominated in domestic currency (both the banks and the counterparties), to move in opposite directions. • This creates an externality or external wealth effect for the financial system. • The Bank wealth effect • The Client Wealth effect

20. The Bank Wealth effect • An exchange rate appreciation will… • …reduce the value of foreign items on the banks' balance sheet and boost its equity ratio since it is denominated in domestic currency. Thus, the capital charges arising from foreign currency lending are lowered. • ...reduce the burden of foreign debt and improves the credit risk of banks' loan portfolio. Thus, the risk weighted capital charges are lowered. • ...improve the net asset position of the wider economy, increasing money demand and boosting creation of sight deposit (M1) which is cheapest source of domestic financing for the banks. Thus, the average cost of domestic financing is reduced in the banking system

21. The Client Wealth effect • An exchange rate appreciation will benefit those carrying unhedged currency risk whose booked value of foreign debt will be reduced. • Greater collateral, net of debt, rises, improving their risk rating, and increasing demand for new loans. • Greater wealth, as well as lower import prices, will stimulate aggregate demand and improve economic fundamentals. • These two wealth effects are mutually reinforcing, increasing demand for domestic assets, including domestic currency, leading to a further currency appreciation

22. Moreover,… • Foreign loans are usually taken in order to invest or purchase some assets. • Therefore, the acceleration of foreign re-lending usually corresponds to higher asset prices which will increase banks´ profits as well as the income of their clients. • In many currency dependent economies, large increase in bank equity have preceded banking crisis. • Foreign currency lending can create a virtuous cycle of demand for domestic currency and domestic assets, and appreciation of the exchange rate.

23. Wealth creation at the eve of crisis

24. Up by the escalator • Similarly, a depreciation will have a negative wealth effect, but at a much faster rate, a phenomena described by the “up by the stairs, down by the elevator” principle. • The currency appreciation and wealth creation is usually gradual, and the depreciation and wealth destruction fast and violent. • As the net asset position is increased, and the economy heats up, an increasing number of informed agents build up an expectation of a currency depreciation. • Nobody wants to be the last to hedge their currency positions, and a large number of agents may attempt to reverse their positions simultaneously. • As the result, the exchange rate fall very drastically as the as domestic agents try to hedge their currency risk by aquiring foreign assets and/or selling domestic assets.

25. Down by the Elevator • The boom is gradual, the crash is rapid and violent. • Rapid exchange rate depreciation causes the value of debts and assets to move in opposite directions, leading to wealth destruction and credit crunch. • See e.g. Kaminsky & Reinhart (2000) on the stylized facts of the twin crisis, how a collapse in the exchange rate leads a banking crisis in 6-12 months.

26. Monetary policy in currency dependent economies

27. (In)effectiveness of Monetary policy • For currency dependent economies in a boom, interest rate increases may have the perverse effect of stimulating the economy in the short-run. • Higher interest rates increase spread between foreign and domestic loans, increases the attractiveness of foreign lending, • The resulting exchange rate appreciation creates positive wealth effects which may stimulate aggregate demand as well as asset markets. • At least, contractionary monetary policy, might do little to constrain banks that are experiencing rapid improvements of their equity position and lower capital charges.

28. (In)effectiveness of Monetary policy • Similarly, an expansionary policy in times of crisis is likely to backfire with a further depreciation of the exchange rate and wealth destruction. • In fact, policy responses to currency and bank crisis in currency dependent economies have invariably been procyclical. E.g. in the Asian crisis, Chile, etc. • Authorities are forced to respond to negative shocks with a monetary contraction and higher interest rates to shore up the exchange rate against a massive outflow of foreign currency. • They even have to inject new bank capital into the system or take over failed banks in order to prevent a collapse of the financial system.

29. Proposals

30. Summary of Problem • If foreign exchange risk is not properly incorporated in banks’ regulatory capital, the banks have incentives to lend excessively in booms, and contract excessively in crisis • One reason is wealth effects • banks • and their borrowers • and even 3rd parties

31. What to do? • measure currency risk correctly: probably impossible • or expose banks to currency risk by other means We can either:

32. Proposal • Capital charges arising from foreign currency lending could be in the same currency, so e.g. • A bank in Poland making a Euro loan of €100, would carry its capital charge from that loan in Euros, i.e. 8% risk weighted of the €100

33. Implications • Capital charges from foreign currency loans are countercyclical • Monetary policy is more effective • Lower currency reserves needed by the Central Bank

34. The ratio of currency linked loans out total loan portfolio in the Icelandic banking system