From Basel I to Basel II: Implications and Challenges for Emerging Markets

1. From Basel I to Basel II: Implications and Challenges for Emerging Markets Liliana Rojas-Suarez

2. 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.

3. Background: Capital Requirements Have Not Always Constrained Risk-Taking Behavior of Banks in Many Emerging Markets 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…

4. Background: Capital Requirements Have Not Always Constrained Risk-Taking Behavior of Banks in Many Emerging Markets …and capitalization ratios have performed very poorly as early-warning signals of banking crises.

5. 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. The well-known condition related to the appropriate accounting, regulatory, supervisory and judicial frameworks. II. Capital requirements need to reflect the “true risk” of a bank’s portfolio.

6. 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.

7. How the “Application” of Basel may weaken banking systems in Emerging MarketsExample 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.

8. How the “Application” of Basel may weaken banking systems in Emerging MarketsExample 1: Treatment of Bank Credit to the Government The regulatory treatment of government paper contributes to exacerbate recessions.

9. How the “Application” of Basel may weaken banking systems in Emerging MarketsExample 1: Treatment of Bank Credit to the Government EMBI Spread and Claims on Government as Percentage of total assets of deposit money banks 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.

10. Example 2: Rules on Interbank Lending Basel’s treatment of interbank lending to non-OECD countries has reduced the maturity of loans to emerging markets.

11. 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.

12. 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. ,

13. 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: • a. If banks in industrial countries use the internal rating- 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 (overestimated) risk to emerging markets materializes, international banks will quickly reverse (increase) the flows to micro-manage capital requirements.

14. 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.

15. 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. \

16. Challenges from Supervisors in Emerging Markets derived from Basel II • 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.

17. 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.

18. 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.

19. Policy Recommendations for Emerging Markets • Basic weakness in regulatory and supervisory framework need to be addressed before implementing the new Accord. • 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.

20. 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.