A Capital Accord for Emerging Economies?

1. A Capital Accord for Emerging Economies? Andrew Powell Universidad Torcuato Di Tella and Visiting Research Fellow, The World Bank (Financial Sector Strategy and Policy - FSP) July, 2001

2. Motivation • BCBS has published a proposal to change the 1988 Capital Accord • The 1988 Accord was perhaps the most successful of all ‘financial standards’ • Will the ‘New Accord’ be so successful ? • Implications for emerging economies: • Cost of capital • Issues regarding implementing the New Accord • Acknowledgements, but views strictly my own

3. Part 1:On the 1988 Accord and the Proposals

4. On the 1988 Accord... • Designed by G10 supervisors and aimed at their ‘internationally active banks’. • But, very successful - applied in at least 100 countries and in many for all banks (Barth, Caprio and Levine 2001) • Easy to criticize such a simple yardstick as ‘assets at risk’ but the simple standard: • Created a type of yardstick competition • Was adapted to local conditions • Was easy for legislators to understand

5. The ‘New Accord’: Overview • The New Accord • Pillar 1: Requirements • Pillar 2: Supervisory Review • Pillar 3: Market Discipline • Supporting Documents on the above and on operational risk, interest rate risk, asset securitization etc. • this presentation focuses on Pillar 1 and within that on capital requirements for credit risk.

6. Pillar 1: Requirements • Capital Requirements • Standardized • Internal Ratings • Sovereign, Corporate, Bank, (Retail) • Enhanced rules for credit risk mitigation techniques

7. The Standardised Approach

8. The Standardized Approachfor Sovereigns • Survey evidence says banks rely on rating agencies. • Banks have no superior information or are they just equally at a loss ? • There has been a focus on pro-cyclicality • But up-front provisions already pro-cyclical • Are banks more pro-cyclical than the agencies? • But, rating agencies may just get it wrong! • Very few opinions, assessments subjective but of systemic impact (for country). • And there may be circularity.

9. The IRB Approach • Calibrated on experience with corporate claims and applied to Sovereign, Bank and Retail. • Method draws on advances in risk management in large banks. • Banks must slot claims into Borrower Grades (minimum of 6-9 for performing and 2 for non-performing) • Grades ‘mapped’ into Default Probabilities

10. On Model Calibration • Uses Merton risky debt model, Creditmetricstm probability transition matrix and G10 corporate default experience. • Calibrated to cover expected and unanticipated losses to 99.5% tolerance value. • We are told that a 3 year loan with a PD=0.7%, LGD=50% and average asset correlation of 20% gives a risk weight of 100% (i.e.: an 8% capital requirement).

11. Some Maths… BRW = Benchmark risk weight, N(.) is cumulative normal, G(.) is the inverse cumulative normal, PD is probability of default and LGD is Loss Given Default. Subsequent adjustments may then be made for maturity and ‘granularity’.

12. IRB Approach for Sovereigns • AAA’s – A’s get PD=0 • No rules on how many sovereigns in each Borrower Grade. • The remainder of the calibration follows that for corporates.

13. Part 2On the Cost of Capital forDeveloping Economies

15. Implications of the Proposals • For IRB approach, Required Capital much more sensitive to PD at higher levels of PD. • This “convexity” of IRB approach, a consequence of credit risk mathematics (not clear how the standardized approach is ‘calibrated’). • Perverse incentives for banks ? • Estimates of effects on spreads…

17. Source: author’s calculations based on S&P ratings and BIS consolidated claims on developing economies and some strong assumptions!

19. An alternative IRB Approach for Sovereigns • Banks must assign an ‘internal’ rating on a Moody’s, S&P or Fitch type scale • Capital Requirements are then given by the relevant bucket in the standardized approach  Given the uncertainty of applying the corporate-calibrated, IRB approach to sovereigns, this would create a less controversial and less convex scale.

20. Part 3:How Emerging Economiesmay implement the New Accord

21. Implementing the New Accord :Two important issues • Level of Consolidation • consolidation required to one level above internationally active bank • but many emerging economies have not yet implemented consolidated supervision • Related Lending • material exposures of more than 15% (individual) and 60% (aggregate) deducted from capital

22. Standardised versus IRB approach? • The standardised Approach would lead to little change due to the limited universe of rated institutions (eg: Argentina has about 150 rated corporates but there are 25,000 corporates in the BCRA ‘credit bureau’) • Or, very sharp rise in demand for ratings and potential ‘race to the bottom’ in terms of rating quality. • The Internal Ratings approaches will be very difficult to implement  Likely result: will ‘implement’ the standardised approach and little will change (execpt enhanced rules on collateral and other supporting documents – Pillars 2 and 3 etc.)

23. Provisions and Capital • In Latin America: • some regulators have more legal autonomy to determine provisions, capital requirements are determined in laws • provisions do not only reflect ex post accounting losses • level of provisioning often higher than in G10 • in some countries, provisions set through highly developed credit bureau policies in attempt to reflect expected losses

25. More general points regarding model calibration... • Obvious doubts: • As models are non-linear, difficult to re-calibrate to local conditions (not clear what 11.5% and not 8% means), needs full re-calibration • Not clear whether the correlation of 0.2 nor the ‘granularity’ adjustment are appropriate in emerging economies with less diversifiable risk.

26. On Minimum Requirements for Internal Rating Authorisation • The focus is on a bank developing an internal rating system, for that system to satisfy a set of minimum requirements and to be integral to the bank’s operations. • Would give a degree of autonomy in setting regulatory capital that many emerging economy supervisors may find unacceptable. • Minimum laid down requirements for the rating process may not ‘fit’ emerging economy data.

27. Credit Bureau Policies • At the same time, some emerging countries have developed ‘credit bureau’ policies. Miller (2000) “Credit Reporting Systems around the Globe”, provides a review. • In 21 of the 30 countries reviewed, there is a rating/grade (normally 5 or 6) and in most cases this is set by the bank but scrutinised by the regulator. • The objectives have been to improve the information in the financial system but in many cases the ratings feed directly into provisioning requirements.

28. The Credit Bureau Policy of the Central Bank of Argentina • Started in 1992, gradually increasing in coverage, now all loans > $50, 8 million entries per month. • 5/6 grades: 1 and 2 performing, 3-5/6 non-performing (does not satisfy Basel II). • Database available for individual inquiries free through the internet, all information >$200k and ‘good’ information >$200k ‘sold’ on a cd • Corporate >200k grades forward looking (ex ante), retail grade is function of arrears (ex post). • Feeds directly into provisioning requirements

29. Use of Credit Bureau Data to Assess Capital Requirements • Anticipated and unanticipated losses: two statistics from the same distribution • Can use non-parametric models (eg: Carey 2000 and Falkenheim and Powell 2000) or parametric models (eg: Creditmetricstm) or study the probability of default from a credit scoring model with a parametric model (eg: Creditrisk+tm) to determine anticipated and unanticipated losses. • Central Bank of Argentina has Creditrisk+tm up and running with a preliminary credit scoring model.

31. Emerging Country Supervisors face a difficult choice • Use model results to re-calibrate internal ratings approach to local conditions. • Adapt ‘credit bureau’ policies to ‘fit’ minimum laid down standards. • Use existing credit bureau policies as a basis for PD estimates.

32. Another Alternative is to Develop a Separate StandardFor Emerging Economies Autonomy Flexibility Simplicity Complexity Standardization Control

33. Conclusions • 1988 Capital Accord was a tremendous success • The ‘new Accord’: • May imply significant increases in the cost of funds for lower rated emerging economies. • Regarding implementation, may be largely irrelevant (standardised approach) or difficult (IRB) approach. • The more the New Accord ‘fits’ risk management policies of large international banks, the less it may fit most banks in emerging economies • The time has come to think about a new Accord for emerging economies