Comments on Panel:Comments on Panel:Basel II and Emerging MarketsBasel II and Emerging Markets

Liliana Rojas-SuarezSenior Fellow

Center for Global Development

London School of EconomicsApril 2005

What I liked in the papers:What I liked in the papers: The explicit (or implicit) prioritization of “economic” capital

as a guiding tool for banks’ allocation of risk. The recognition of the role of markets (through Pillar 3 of

Basel II) in enhancing banking strength. Most importantly, there is consensus that Emerging Market

countries should not rush into Basel II. There is recognition about the concerns raised by Emerging

Markets, especially those related to:• The potential increase in the procyclicality of capital flows• Potential for competitive problems and distorted playing field, since

subsidiaries of foreign banks and local banks might use different capital standards.

A comment on Gerd Häusler’s paperA comment on Gerd Häusler’s paperWhile the IMF recognizes concerns raised by Emerging Markets, I view the role of the Fund as “too passive”.For example:• In the standardized approach, Basel II lowers the maturity

of interbank loans subject to lower capital charges (preferential treatment). This implies that some foreign banks will have an incentive to shorten the maturity of loans to emerging markets. Since this adversely affects countries’ current efforts to lengthen the maturity structure of foreign liabilities, doesn’t the IMF believe that Basel II might clash with the objective of financial stability?

• Improving supervisory practices and implementation of Basel Core Principles is certainly necessary, but what additional policies particular to the features of emerging markets does the IMF recommend?

A comment on Jerry Caprio’s paperA comment on Jerry Caprio’s paper Goes to the heart of an important weakness of Basel

(I and II), namely the assumption in the Accord that countries have an adequate institutional and political framework.

Makes a strong case regarding the ineffectiveness of government interventions in autocratic political systems.

Rescues the role of Pillar 3 of Basel II. But in my view, falls short in providing specific

recommendation on what emerging markets should do with their existing capital requirements at home.

What I missed in the papers:What I missed in the papers:

Two related issues:I. What is needed for any capital requirement to

work in emerging markets given their particular features that distinguish them from industrial countries?

II. What kind of alternative policies (besides improved supervision and adoption of Basel Core Principles) might be needed in Emerging Markets to effectively improve capital requirements? (Daníelson & Jónsson paper has something to say in this regard)

I. What is needed for any capital requirement I. What is needed for any capital requirement to work in Emerging Marketsto work in 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…

Capital requirements have not always constrained risk-taking behavior of banks in many emerging markets

Real Net Equity Growth in Selected Banking Systems at the Eve of a Crisis(in percent)

-20

-10

0

10

20

30

40

Norway

199

1

Sweden

199

1

Japa

n 19

94

Argen

tina

1993

Mal

aysia

199

6

Thaila

nd 1

996

Mex

ico 1

993

Ecuad

or 1

995

I. What is needed for any capital I. What is needed for any capital requirement to work in Emerging Marketsrequirement to work in Emerging Markets

For capital requirements to work as effective indicators of bank strength two sets of conditions must be met:

a) The well-known condition related to the appropriate accounting, regulatory, supervisory and judicial frameworks.

b) Capital requirements need to reflect the “true risk” of emerging market bank’s portfolio. And this might be extremely difficult since there are no deep capital markets that validate the quality of reported capital.

I. What is needed for any capital I. What is needed for any capital requirement to work in Emerging Marketsrequirement to work in Emerging Markets

For example, advising Emerging Market countries to continue on Basel I will continue encouraging banks to hold government paper at the expense of private sector loans, as there are no local capital markets that penalize excessive risk taking of banks

Claims on central and noncentral government as a percentage of total assets of deposit money banks

1980-1989 vs. 1990-2004*

CHISGP

MYSTHA

KOR

PER

ECU

COL

PHL

ISR

VEN

IDN

BRA

ARG

POL

HUN

TUR

IND

MEX

0

5

10

15

20

25

30

35

40

45

50

0 5 10 15 20 25 30 35 40 45 50

Average 1990-2004

Av

era

ge

19

80

-19

89

* Or latest availableSource: IMF, International Financial Statistics (March 205)

I. What is needed for any capital I. What is needed for any capital requirement to work in Emerging Marketsrequirement to work in Emerging MarketsContinuing with the “wrong” pricing of risks in Emerging Markets, especially that of the regulatory treatment of government paper contributes to exacerbate recessions…

Economic Activity and Banks' Claims on Government as Percentage of Total AssetsTotal claims on government as percentage of total assets of deposit money banks

---------- GDP Growth Rate

Source: IMF (2002) International Financial Statistics ; World Bank (2001) World Development Indicators and private sector forecasts.

Argentina

-20.0

0.0

20.0

40.0

1997 1998 1999 2000

Turkey

-100.0

0.0

100.0

1997 1998 1999 2000

total claims ongovernment as

GDP growth rate

Venezuela

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

1997 1998 1999 2000Argentina

-10.00

-5.00

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

1997 1998 1999 2000 2001

Turkey

-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

50.00

60.00

1997 1998 1999 2000 2001

I. What is needed for any capital I. What is needed for any capital requirement to work in Emerging Marketsrequirement to work in Emerging Markets

… and weakens the quality of bank assets. For example, previous to their crises, banks in Argentina and Turkey continued to increase their relative holdings of government paper even when the international bond markets had signaled increased “riskiness” for these assets.

EMBI Spread and Claims on Government as Percentage of total assets of deposit money banks

Argentina

20

22

24

26

28

30

32

Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

Claims on government EMBI Spread

Turkey

20

25

30

35

40

45

50

55

60

Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01

0

200

400

600

800

1000

1200

Claims on government EMBI Spread

In addition to addressing basic weakness in legal, judicial, regulatory and supervisory framework……In the Transition towards an industrial-country-like capital standard, design a capital standard that appropriately reflects the risks of banks’ assets in emerging markets. That is, modify current capital requirements to:– Initiate risk-based regulations in loan loss provisions (ex-ante provisioning

system)– Maintain a simple classification of assets according to risk but drastically

modify the risk categories.Two examples:

– Appropriate risk assessment of government paper (rather than the zero risk weight used by most emerging markets)

– Credit risk distinction between borrowers from tradable and non-tradable sectors.

II. Then, what are adequate alternative or maybe II. Then, what are adequate alternative or maybe “transitional” policies?“transitional” policies?

And, therefore, a comment on And, therefore, a comment on Daníelson - JónnsonDaníelson - Jónnson– What the authors call “currency dependence” is known as the

problem of “liability dollarization” in emerging markets.– “Exchange rate risk” becomes “credit risk” in economies suffering

from liability dollarization (see Rojas-Suárez, 2001).– While the authors’ proposal to denominate capital charges arising

from foreign currency lending in the same currency is certainly helpful to deal with the procyclicality issue, it still does not fully take into account two features of emerging markets:• Exchange rate depreciations bring a reduction in the capacity of the non-

tradable sector to service its foreign-denominated loans.• Sharp depreciations of the exchange rate are a recurrent feature in these

countries.

Together, these two factors seem to indicate that ex-ante bank provisioning requirements need to be higher for loans to the non-tradable sector.

What else can be done in the near future?What else can be done in the near future?

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.