Revised Capital Rules from the Perspective of Emerging Markets

1. Revised Capital Rules from the Perspective of Emerging Markets David Carse Deputy Chief Executive Hong Kong Monetary Authority 24 November 1999

2. Basel Committee’s relationship with the emerging (non-G10) markets • The Basel Committee (BC) is increasingly, and more explicitly, becoming the standard setter for banking supervisors around the world • The Core Principles have given added impetus to the BC’s liaison with non-G10 supervisors

3. The Core Principles Liaison Group • Comprises both G10 and non-G10 supervisors (plus IMF, World Bank, ECB) • Original purpose was to assist in the drafting/consultation process on the Core Principles • Has since developed into a broader consultative role, including on the new Accord • CPLG Working Group on Capital set up for this purpose

4. Other channels for liaison • Ad hoc participation by non-G10 experts in BC’s working group meetings • More workshops for G10 and non-G10 supervisors on a variety of subjects • Regular meetings with chairmen of the regional supervisory groups such as the EMEAP Working Group on Banking Supervision which Hong Kong chairs • The “non-G10” views expressed in this presentation are based on those of CPLG and EMEAP Working Group members

5. Reaction of the non-G10 supervisors • The non-G10 supervisors generally welcome the opportunity to engage in the activities of the BC • There are however some skeptics who see it only as a means of the BC to claim legitimacy for decisions by G10 countries • It is important therefore for the BC to take non-G10 views fully into account • It may be necessary in due course to widen the membership of the BC

6. Hong Kong’s position under the new Accord • HK is non-OECD but rated “A” by S&P • We aim to comply fully with the Core Principles and we subscribe to the SDDS • We already apply the Pillar 2 and 3 approach • The capital ratio for the system as a whole is currently around 19% • The impact of the new Accord is estimated to reduce the ratio by less than 1%

7. Overview of non-G10 reactions to the new Accord • Non-G10 supervisors generally support the demise of the OECD Club Approach • They support the idea of more closely aligning capital with underlying risk • They acknowledge the importance of supervisory review and market discipline • BUT, there are important doubts/reservations about various aspects of the new Accord • some of these concerns are shared by G10 countries

8. Areas of concern • The impact on cost of funds and flow of funds to non-G10 countries • Coverage of the Accord • Use of external credit rating agencies • Option 1 versus Option 2 • The linkage with international standards • The applicability of the internal ratings approach • The charge for interest rate and other risks

9. The impact on non-G10 countries • There is a view among some non-G10 countries that the new Accord has been developed primarily for the benefit of G10 sovereigns, banks and corporates • Many non-G10 countries are still struggling to meet the old Accord and improve quality of supervision and transparency • For such countries, the concern is that their access to international markets and cost of funds will be adversely affected

10. The coverage of the Accord • What is the “target audience” of the new Accord? • The BC’s continued focus on “internationally active banks” seems unrealistic • the new Accord will become a de facto world standard and the interests of the non-G10 countries should therefore be taken into account • The non-G10 majority preference is for a unified Accord to which they can subscribe • a separate version for non-G10 countries would be seen as second-class • but there should be options within the Accord that would be suitable for non-G10 countries

11. Use of external credit rating agencies • The use of external CRAs is the most controversial aspect of the new Accord • Some of the opposition is simply a natural dislike of criticism from outsiders (such as CRAs) that is perceived to be “unfair” • But the role of the CRAs during the Asian crisis has raised legitimate questions about giving them a greater role in the regulatory process • Even the BC itself seems lukewarm about the use of CRAs

12. Issues arising from use of CRAs • The credibility and track record of the CRAs, particularly as regards sovereign risk • The greater procyclical bias that would be introduced into the capital charge • Competitive inequality caused by limited penetration of external ratings in the non-G10 • The accountability of the CRAs (and the possible need for regulation) • Surrender of responsibility by regulators to CRAs

13. Procyclicality • The use of credit ratings means that capital requirements would increase as borrowers were downgraded • Arguable that banks should set aside more capital as risk increases • But the concern (shared by the IMF) is that every bank would do this at exactly the same time • increase the tendency for banks to rush for the exit • would have made it more difficult to maintain the standstill for Korean banks at end-1997

14. Anticyclicality • There is general agreement that supervisors should try to encourage banks to build up a capital cushion in the good times to allow for a decline in capital ratios in the bad times • Dynamic provisioning can also help to insure banks against future downturns • But this does not remove the threat that a ratings downgrade would cause a sharp portfolio reallocation in times of stress

15. The case of Korea Date S&P rating Risk weight# 21/6/97 AA- 0 24/10/97 A+ (-1)* 20 25/11/97 A- (-3)* 20 11/12/97 BBB- (-6)* 50 22/12/97 B+ (-10)* 100 * cumulative change in rating “notches” #if the new Accord had been in effect

16. The case against the CRAs performance in the Asian crisis • The allegation is that the CRAs were over-optimistic in their ratings prior to the crisis and then too aggressive in downgrading • This is said to have contributed to the abrupt reversal of capital flows to the Asian countries: “Rather than being an important independent stabilizing force, the major credit rating agencies did not behave very differently from the vast majority of market participants.” (IMF International Capital Markets Report 1999) • Use of the CRAs’ ratings for capital purposes would not have led to capital being built up in advance of the crisis against countries like Korea

17. Have the CRAs learned the right lessons? • In the light of this, should the BC make use of the CRAs for sovereign and bank risk? • The CRAs have of course defended their role in the crisis, but they have also acknowledged that there are lessons to be learned, eg • need for greater focus on banking sector weakness • greater emphasis on the risks of leverage and particularly of short-term debt • increased sensitivity to contagion risk • increased focus on transparency • need to devote more resources to sovereign ratings

18. Alternatives to the CRAs • Notwithstanding these changes, the non-G10 countries remain opposed to the use of CRAs • Nor are they keen on the use of export credit rating agencies • Some have suggested that the IMF should take on the role of issuing sovereign ratings • but the IMF does not have the resources to do this and it would create conflicts of interest • One option would be to retain the present standardized approach despite its flaws - but the BC seems determined to change it • Hence, there seems no alternative to CRAs

19. Option 1 versus Option 2 • If the CRAs are to be used, a number of detailed issues arise on the structure of the risk weights • In particular, there is the question of which option should be used for interbank exposures • In general, non-G10 countries favour the use of Option 2, ie ratings directly assigned to banks • no necessary correlation between the risk of a bank and that of its sovereign (to the extent that there is a link, it is already built into the bank’s rating) • Option 1 too directly implies Government support for banks

20. Higher risk categories • Some non-G10 countries are worried that the 150% weight will require higher capital on top of higher provisions as creditworthiness deteriorates • Others (including Hong Kong) see it as a useful means of differentiating credit risk • There is the issue of which exposures should fall within this category • one suggestion is that it should include exposure to HLIs which fail to provide sufficient information to lenders or which are unrated

21. Other CRA issues • The criteria for recognition of CRAs and whether this should be left to national discretion • The incentives in the proposed structure for some borrowers not to be rated • The types of credit ratings that will be used - in particular, will unsolicited ratings be eligible? • The sharp discontinuity in some of the risk weights (eg between AA- and A+ rated corporates)

22. The internal ratings approach • It is still unclear how this will work and to whom it will be applicable • The BC originally seemed to envisage that it will apply only to “some sophisticated banks” • But a number of “sophisticated” banks in non-G10 countries may also wish to use this option • need for consistent international standards • non-G10 supervisors will need to have adequate resources to validate banks’ rating systems and processes

23. The linkage of the capital charge with international standards • This proposed linkage with the Core Principles and the IMF’s SDDS is controversial • There is greater acceptance of use of the Core Principles as a precondition for lower capital requirements for claims on banks • but the precondition is currently somewhat vague since it allows for countries simply to be in the “process of implementing” the Core Principles • some supervisors stress that there is a need for clear independent assessment of implementation • others argue that compliance with the Principles is not supposed to be a simple matter of pass/fail

24. The linkage with SDDS • There is much more opposition to any linkage with SDDS for sovereign risk • only 47 countries have subscribed to SDDS • difficult to assess compliance with SDDS • some countries believe that it is fundamentally incorrect to link capital standards to SDDS - no necessary connection between transparency and relative financial strength • The Asian crisis however shows that lack of transparency can destabilize both a country and its banks, and increase the riskiness of claims on these

25. Interest rate risk and other risks • There are doubts about whether risk-sensitive methodologies for measuring the capital charge can be developed, particularly for operational risk • If there is a charge for interest rate risk it should be applied not simply to outliers • However, there is a view that the main supervisory concern with such risks should be with banks’ systems of control rather than with attempts to quantify a capital charge • The capital aspects should be dealt with by requiring a bigger cushion of capital under Pillar 2

26. The other two pillars • These are not particularly controversial among the non-G10 countries • A number of supervisors (like Hong Kong) already mandate minimum capital ratios above the 8% minimum and set different ratios for different banks • However, there is concern that some supervisors may not yet possess the skills and resources to implement the recommendations fully

27. Conclusions • The non-G10 countries generally support the direction in which the BC is moving • The problem is that they disagree with a number of the important details released so far • This is going to pose a problem for the BC - the more widely it consults, the more divergent views it is going to receive • But to raise supervisory standards worldwide, it is important that the BC tries to take the broader supervisory community with it - as it did with the Core Principles