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The BIS Regulatory FrameworkThe BIS Regulatory Framework and Icelandic Banking Sector:and Icelandic Banking Sector:

Issues and DilemmasIssues and Dilemmas

Seminar at the Central Bank of IcelandSeminar at the Central Bank of Iceland

February 18, 2002February 18, 2002

Gudmundur MagnussonGudmundur Magnusson

Saso AndonovSaso Andonov

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I. The Original (Old) Basle Accord I. The Original (Old) Basle Accord (1988) – EU and EEA (1993)(1988) – EU and EEA (1993)

Financial stabilityFinancial stability Levelling of the competitive fieldLevelling of the competitive field Minimum requirementsMinimum requirements StandardizationStandardization Credit riskCredit risk SimplicitySimplicity

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II. The Basle Proposals for Market II. The Basle Proposals for Market Risk – VAR (1993 and 1995)Risk – VAR (1993 and 1995)

Internal Value at Risk models;Internal Value at Risk models; Approval by supervisory authorities;Approval by supervisory authorities; Trade off between CAR and VARTrade off between CAR and VAR

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III. The New Basle Accord – ProposalsIII. The New Basle Accord – Proposals Still more financial stability;Still more financial stability; More differentiated measures of credit riskMore differentiated measures of credit risk Other types of risk (liquidity, operational, Other types of risk (liquidity, operational,

legal risk);legal risk); Supervisory review process;Supervisory review process; More transparency; More transparency; Enhanced market disciplineEnhanced market discipline

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IV. Points for Discussion: IV. Points for Discussion:

Comparison of the New and the Old rules Comparison of the New and the Old rules and potential and potential implications of the new standards for credit risk;implications of the new standards for credit risk;(a) Choice between two alternative approaches: the standardized (a) Choice between two alternative approaches: the standardized

approach (SA) and the internal ratings based approach (IRBA).approach (SA) and the internal ratings based approach (IRBA).

SA – external credit assessmentSA – external credit assessment

IRBA – own internal rating of borrowers (two options: foundation IRBA – own internal rating of borrowers (two options: foundation approach or own estimates) approach or own estimates)

(b) (b) Supervisors could require higher that the minimum capital target;Supervisors could require higher that the minimum capital target;

(c) IRBA more risk sensitive; good for big banks, bad for small?(c) IRBA more risk sensitive; good for big banks, bad for small?

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Price Structure of Credits With and Price Structure of Credits With and Without Use of Credit ModelsWithout Use of Credit Models

Yield Practice with credit model Current practice Risk

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Proposals and PracticeProposals and Practice

Cost of capital versus risk-adjusted rate of Cost of capital versus risk-adjusted rate of return;return;

Credit risk models in practice;Credit risk models in practice; VaR models, insurance-inspired models, VaR models, insurance-inspired models,

Option-based models;Option-based models; Acceptance by supervisory authoritiesAcceptance by supervisory authorities

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Points for Disscusion – cont.Points for Disscusion – cont.

(d) More average capital needed as a cushion (d) More average capital needed as a cushion for macfor macrroeconomic fluctuations?oeconomic fluctuations?

(e) Small countries and small banks will (e) Small countries and small banks will suffer?suffer?

(f) Manna from heaven for the rating (f) Manna from heaven for the rating agencies?agencies?

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V. Comprehensive Risk Management on V. Comprehensive Risk Management on the Banking Industry Levelthe Banking Industry Level

Comprehensive versus narrow scope of banking;Comprehensive versus narrow scope of banking; Investment banks and commercial banks;Investment banks and commercial banks; New types of instruments;New types of instruments; Accounting standards;Accounting standards; Disintegration of banking;Disintegration of banking; Globalisation;Globalisation; Lender of last resort;Lender of last resort; Regulatory arbitrageRegulatory arbitrage

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D.T. Llewellyn: Assessing the New D.T. Llewellyn: Assessing the New Basle Capital AccordBasle Capital Accord

Criteria for judging the effectiveness of any capital Criteria for judging the effectiveness of any capital adequacy regime – the following twelve tests are adequacy regime – the following twelve tests are suggested:suggested:

1.1. Does it have the effect of aligning the regulatory and Does it have the effect of aligning the regulatory and economic capital?economic capital?

2.2. Does it create incentives for effective and efficient risk Does it create incentives for effective and efficient risk analysis, management and control mechanisms;analysis, management and control mechanisms;

3.3. Does it create appropriate incentives for the correct pricing Does it create appropriate incentives for the correct pricing of the risk?of the risk?

4.4. Does it creates incentives for an efficient allocation of Does it creates incentives for an efficient allocation of capital within the bank?capital within the bank?

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cont.cont.5.5. Does it create perverse incentives for regulatory arbitrage?Does it create perverse incentives for regulatory arbitrage?

6.6. Does it create unwarranted entry barriers?Does it create unwarranted entry barriers?

7.7. Are the capital requirements competitively neutral?Are the capital requirements competitively neutral?

8.8. Are the requirements appropriate for overall portfolio risk, Are the requirements appropriate for overall portfolio risk, as opposed to the sum of project risks?as opposed to the sum of project risks?

9.9. Does it have the effect of impairing competition in banking Does it have the effect of impairing competition in banking markets?markets?

10.10. Does it have unfavourable effects on the macroeconomy;Does it have unfavourable effects on the macroeconomy;

11.11. Is the new Accord unnecessarily complicated? Is the new Accord unnecessarily complicated?

12.12. Does it create or reinforce incentives for shareholders and Does it create or reinforce incentives for shareholders and other official supervisors to monitor the risks of banks and other official supervisors to monitor the risks of banks and for market discipline to be exercised?for market discipline to be exercised?

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VI. VI. CAR of the Icelandic Banking SystemCAR of the Icelandic Banking System::1989-20011989-2001

9 19899,7 19908,7 19919,5 19928,9 1993

10,7 199413,6 199511,1 199610,7 19979,9 19989,8 1999

10,6 20009,90 2001

Iceland: Commercial and Savings Banks Capital Adequacy Ratio 1989-2000

0

2

4

6

8

10

12

14

16

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

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Second: the Alternative OneSecond: the Alternative One Financial Supervisory Authority of Iceland:Financial Supervisory Authority of Iceland:

– "The FSE has also declared that large Icelandic credit "The FSE has also declared that large Icelandic credit institutions, even showing an effective risk management and institutions, even showing an effective risk management and internal control, should at least aim for a minimum of a 10% CAD internal control, should at least aim for a minimum of a 10% CAD ratio. Other credit institutions should aim for a higher CAD ratio". ratio. Other credit institutions should aim for a higher CAD ratio". Annual Report, 2000Annual Report, 2000

Central Bank of Iceland:Central Bank of Iceland:– "The capital ratio of the financial institutions as a whole has been declining in "The capital ratio of the financial institutions as a whole has been declining in

recent years. At the end of 2000 it measured 9.9%, down from 10.6% the recent years. At the end of 2000 it measured 9.9%, down from 10.6% the previous year. The commercial banks failed to reach their target of maintaining previous year. The commercial banks failed to reach their target of maintaining capital ratios of 10% and above last year". capital ratios of 10% and above last year". CB of Iceland Monetary Bulletin, CB of Iceland Monetary Bulletin, Financial Stability, 2001Financial Stability, 2001,,

International Monetary Fund:International Monetary Fund:– "Decline in Icelandic banks’ CARs (both including and excluding subordinated "Decline in Icelandic banks’ CARs (both including and excluding subordinated

loans), reflect the continued expansion of banks’ balance sheets without a loans), reflect the continued expansion of banks’ balance sheets without a corresponding increase in capital, as well as losses sustained on portfolio corresponding increase in capital, as well as losses sustained on portfolio investments as a result of the emerging pressures in the domestic and foreign investments as a result of the emerging pressures in the domestic and foreign markets". markets". IMF Iceland Financial System Stability Assessment;IMF Iceland Financial System Stability Assessment;

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Third: From an International Third: From an International PerspectivePerspective

CountryCountry 19971997 19981998

DenmarkDenmark 11.6111.61 11.3211.32SwedenSweden 13.0 13.0 10.8 10.8NorwayNorway 12.6 12.6 12.6 12.6IcelandIceland 9.8 9.8 9.1 9.1FinlandFinland 11.9 11.9 11.5 11.5USAUSA 12.8 12.8JapanJapan 9.1 9.1IsraelIsrael 10.5 10.5

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VIIVII. Vulnerability and CAR in the . Vulnerability and CAR in the Nordic CountriesNordic Countries

Maintaining credible and prudent levels of CAR may Maintaining credible and prudent levels of CAR may provide an efficient mechanism in case of worsening provide an efficient mechanism in case of worsening macroeconomic conditions that may drive the system into macroeconomic conditions that may drive the system into banking crises:banking crises:– It is a critical indicator of a disturbance of any nature in the It is a critical indicator of a disturbance of any nature in the

bank operational environment and will ultimately be reflected bank operational environment and will ultimately be reflected in the changes of this ratio;in the changes of this ratio;

– It can serve as an early warning signal;It can serve as an early warning signal; Point for discussion: Would the banking crises in the Point for discussion: Would the banking crises in the

Nordic countries in the early 90´s have been less adverse if Nordic countries in the early 90´s have been less adverse if agents had maintained higher than the minimum capital agents had maintained higher than the minimum capital standards?standards?

Is the CAR safe at any speed?Is the CAR safe at any speed?

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For Consideration: CAR in the Early 90’sFor Consideration: CAR in the Early 90’s

Lesson: Safety of the CAR depends both on its Lesson: Safety of the CAR depends both on its quality and nature of the environmentquality and nature of the environment

Country CAR Efficiency

Denmark 10% Sufficient

NorwaySwedenFinland

< 10% Insufficient

FaeroeIslands

10% Insufficient

Greenland 10% Sufficient

Iceland < 10% Barelysufficient

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VIVIIIII. The Optimal Size of the CAR. The Optimal Size of the CAR

In economic terms, regulatory capital should not be In economic terms, regulatory capital should not be increased beyond the point where the marginal cost increased beyond the point where the marginal cost outweighs the expected marginal benefit from holding outweighs the expected marginal benefit from holding capital;capital;

The most quoted criteria in determining the size of the The most quoted criteria in determining the size of the CAR are:CAR are:– Cost of raising capital;Cost of raising capital;– Economic cycles and their importance for capital planning;Economic cycles and their importance for capital planning;– Size of the agent and its importance for the volatility of the Size of the agent and its importance for the volatility of the

income streams;income streams;– Access to liquidity including the Central Bank; Access to liquidity including the Central Bank; – Credibility and peer group pressures;Credibility and peer group pressures;

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ModelModellling the Optimality of CARing the Optimality of CAR

In our opinion, optimality of the CAR should be In our opinion, optimality of the CAR should be derived from basic characteristics of the economy, derived from basic characteristics of the economy, both macroeconomic and microeconomic ones;both macroeconomic and microeconomic ones;

For that purpose, we are proposing four variables (or For that purpose, we are proposing four variables (or their proxies) to be taken into account whentheir proxies) to be taken into account when determining the desired capital ratio above the determining the desired capital ratio above the regulatory minimum;regulatory minimum;

The policy rule is based on the weighted differences The policy rule is based on the weighted differences or relative differences of the variables from matching or relative differences of the variables from matching peers (benchmarks);peers (benchmarks);

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Variable Candidates Variable Candidates

Macroeconomic volatility measure:Macroeconomic volatility measure:– Macroeconomic volatility - GDP real growth rate, Macroeconomic volatility - GDP real growth rate,

price level, productivity, terms of trade;price level, productivity, terms of trade;

Diversification measure:Diversification measure:– Sectoral measures - such as loan concentrations Sectoral measures - such as loan concentrations

ratios across sectors;ratios across sectors;– Overall portfolio measures - such as single exposure Overall portfolio measures - such as single exposure

limits; limits;

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continuingcontinuing Microeconomic or banking sector-specific Microeconomic or banking sector-specific

measure measure – Capital strength - such as the size and structure of the Capital strength - such as the size and structure of the

own capital;own capital;– Banking-sector specific volatility, such as bank Banking-sector specific volatility, such as bank

deposits, bank credit to the private sector etc;deposits, bank credit to the private sector etc; Profitability measureProfitability measure

– Banking sector efficiency - measured through pre-tax Banking sector efficiency - measured through pre-tax profits as single measure or through weighprofits as single measure or through weightted index ed index of net interest income, non-interest income, operating of net interest income, non-interest income, operating expenses and the pre-tax profits.expenses and the pre-tax profits.

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)()()()( 4321 AVICAVICAVICAVICIC PPOCOCDDCAR

Formally:Formally:

HypothesisHypothesis + + + + ? ? ? ? Where:Where:

– First term stands for First term stands for macroeconomicmacroeconomic volatility volatility effect;effect;

– Second for Second for diversificationdiversification effect; effect;– Third for Third for microeconomicmicroeconomic or or banking sector-banking sector-

specificspecific one; and one; and – Fourth for Fourth for bank profitabilitybank profitability effect. effect.

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.....)(1 AVICICCAR

Exposition:Exposition:

Theoretically dCAR=α(0.026-0.0098)= α0.0152Theoretically dCAR=α(0.026-0.0098)= α0.0152– where: 0.08 is the mandatory capital requirement;where: 0.08 is the mandatory capital requirement; 0.26 is the standard deviation of the GDP of Iceland 1989-2000;0.26 is the standard deviation of the GDP of Iceland 1989-2000;

0.0098 is the standard deviation of the OECD countries GDP over 0.0098 is the standard deviation of the OECD countries GDP over the same period;the same period;

How to determine or calibrate α?How to determine or calibrate α? The value of the parameter α can be treated as adjustment parameter The value of the parameter α can be treated as adjustment parameter

of the mandatory minimum and it can be derived using cross-country of the mandatory minimum and it can be derived using cross-country panel data estimates;panel data estimates;

In a logarithmic multiple regression framework, α can be interpreted In a logarithmic multiple regression framework, α can be interpreted as an elasticity;as an elasticity;

One can also impose additional restrictions to different parameters or One can also impose additional restrictions to different parameters or group of parameters in order to determine their relative importance.group of parameters in order to determine their relative importance.

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IIXX. Financial Stability Considerations. Financial Stability Considerations

Two-front approach:Two-front approach:– Accounting for structural vulnerabilities;Accounting for structural vulnerabilities;– Improving risk management practices.Improving risk management practices.

Structural vulnerabilities need to be located in the main Structural vulnerabilities need to be located in the main sectors of the economy and assessment to be made as to sectors of the economy and assessment to be made as to how these can be met with corresponding buffers;how these can be met with corresponding buffers;

Concerning risk management practices, the optimal Concerning risk management practices, the optimal trade-off needs to be found concerning market induced trade-off needs to be found concerning market induced vs. regulatory imposed risk management practices, both vs. regulatory imposed risk management practices, both at the banking industry level and the individual firm at the banking industry level and the individual firm level.level.

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Structural Vulnerabilities and BuffersStructural Vulnerabilities and Buffers

Sectors of the Sectors of the EconomyEconomy

Sources of Sources of VulnerabilityVulnerability

BuffersBuffers

Real SectorReal Sector Profit variabilityProfit variability Own capitalOwn capital

Financial SectorFinancial Sector Market Volatility Market Volatility CARCAR

Public SectorPublic Sector

Contingent Contingent LiabilitiesLiabilities

Business CycleBusiness Cycle

Systemic RiskSystemic Risk

Sustainable Sustainable Budget SurplusBudget Surplus

External SectorExternal Sector Currency Currency FluctuationsFluctuations

FX ReservesFX Reserves

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Market-Based vs. Regulatory-Imposed Risk Market-Based vs. Regulatory-Imposed Risk Management PracticesManagement Practices

Market-BasedMarket-Based Predominant role of: Predominant role of:

– Comprehensive risk Comprehensive risk management practices management practices within the banks; VS.within the banks; VS.– CAR, VAR, Credit Risk Modelling etc; CAR, VAR, Credit Risk Modelling etc; – Banks and MUST;Banks and MUST;– Credit Rating Agencies IndicationsCredit Rating Agencies Indications– Transparency of market information Transparency of market information

and active shareholders;and active shareholders;– Mandatory rolling-over of certain part Mandatory rolling-over of certain part

of sub loans on a secondary market.of sub loans on a secondary market.

Regulation-BasedRegulation-Based Predominant role of:Predominant role of:

– FSA power;FSA power;

– Central Bank Regulations;Central Bank Regulations;

– Accounting and Risk Accounting and Risk Management Standards;Management Standards;

– Other government regulation;Other government regulation;

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The Early Experience of the Old Basle The Early Experience of the Old Basle Capital Adequacy Framework: Capital Adequacy Framework:

19881988

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19921992

28

19961996

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Model of Bank Behaviour Model of Bank Behaviour Under Capital RegulationUnder Capital Regulation

)()()(max,,

BISCRRrDrBrLLr RDBLRBL

KDRBLts ..

L

RKBIS

0'',0',0'',0' LLLRR rrrr

L - commercial loans; B - bonds; D - deposits; R - subordinated debts; K - capital; C(.) - cost function of BIS; r - interest rates;

• Variable BIS is defined as:

0'',0' CC

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Nominator vs. Denominator Nominator vs. Denominator Changes of the CAR in G-10Changes of the CAR in G-10

Number of cases where changes in capital and risk-weighted assets contributed positively (+) or negatively (-) to the

change in capital adequacy ratio

Risk-weighted assets

+ - Total

Capital + 18 (19 %) 70 (73 %) 88 (92 %)

- 5 (5 %) 3 (3 %) 8 (8 %)

Total 23 (24 %) 73 (76 %) 96 (100 %)

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Areas of Impact Areas of Impact of the Basle Capital Frameworkof the Basle Capital Framework

Impact on Impact on Bank´s Balance SheetsBank´s Balance Sheets::– Level of Capital Ratios;Level of Capital Ratios;– Structure of Capital;Structure of Capital;– Risk-taking Behaviour;Risk-taking Behaviour;

Capital ArbitrageCapital Arbitrage Effects; Effects; Real SectorReal Sector Effects: Effects:

– Impact on Net Domestic Credit;Impact on Net Domestic Credit;– Impact on Output;Impact on Output;

Impact on Impact on Long-Run CompetitivenessLong-Run Competitiveness of Banks: of Banks:– Banks vs. Other Credit Institutions;Banks vs. Other Credit Institutions;– International Competitiveness Considerations International Competitiveness Considerations

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Contrasting Empirical EvidenceContrasting Empirical Evidence

In adjusting their balance sheets, banks attempted to In adjusting their balance sheets, banks attempted to respond in the least costly way to binding capital respond in the least costly way to binding capital constraints, depending on the cycle and the financial constraints, depending on the cycle and the financial position;position;

Large and growing capital arbitrage may be motivated by Large and growing capital arbitrage may be motivated by other factors, such as taking advantages of economies of other factors, such as taking advantages of economies of scale, better diversification of funding sources etc;scale, better diversification of funding sources etc;

Changes in bank capital affect lending;Changes in bank capital affect lending; Money matters vs. lending matters for output growth;Money matters vs. lending matters for output growth; Evident shift in the funding share by type of agents that can Evident shift in the funding share by type of agents that can

not be attributed solely to the capital regulation;not be attributed solely to the capital regulation; Cost of capital matters.Cost of capital matters.

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The Real Meaning of the The Real Meaning of the Capital Adequacy RatioCapital Adequacy Ratio

The Fundamental Rule:The Fundamental Rule:

Using the Basle model should not mean that the system Using the Basle model should not mean that the system is faithfully copied or not, but whetis faithfully copied or not, but whethher the appropriate er the appropriate adaptations were made to reflect adaptations were made to reflect local conditionslocal conditions;;– Adaptations should be accounted for the risk environment Adaptations should be accounted for the risk environment – Ratio analysis should always be complemented by qualitative Ratio analysis should always be complemented by qualitative

assessment of the bank´s ability to manage its risks; assessment of the bank´s ability to manage its risks;

%8itemssheet balance-Off Assets weighted-Risk

CapitalSecondary Primary

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Other Aspects Deserving Particular Other Aspects Deserving Particular Attention:Attention:

Reliable market pricing of assets, Reliable market pricing of assets, particularly loan portfolio review and assets particularly loan portfolio review and assets classification;classification;

Collateral (re)valuation; Collateral (re)valuation; Loan loss provisioning and all that;Loan loss provisioning and all that; Interest income recognition policies;Interest income recognition policies; Volatility and deepness of the markets of Volatility and deepness of the markets of

operation;operation;

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Iceland Commercial and Savings Banks: Iceland Commercial and Savings Banks: CAR and the Risk ProfileCAR and the Risk Profile

Iceland: Capital Adequacy Ratio, GDP Growth Rate and Lending Growth 1989-2000

-5

0

5

10

15

20

25

30

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

%

Lending Growth GDP Growth CAR

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CAR, Macroeconomy and Banking CAR, Macroeconomy and Banking Sector Indicators: Regression ResultsSector Indicators: Regression Results

Does CAR reflects the macroeconomic Does CAR reflects the macroeconomic development and how macroeconomic development and how macroeconomic shocks are accounted for?shocks are accounted for?

The impact of CAR on bank lending: has The impact of CAR on bank lending: has Icelandic banking sector experienced credit Icelandic banking sector experienced credit crunch as a result of the imposed capital crunch as a result of the imposed capital constraint;constraint;

Structural dimension of the CAR: which Structural dimension of the CAR: which parts tend to add to the rise/fall in the CAR?parts tend to add to the rise/fall in the CAR?

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Variables IncludedVariables Included

– GDPGDP - Real GDP growth rage, as proxy for the overall - Real GDP growth rage, as proxy for the overall macroeconomic stance and the demand side of the bank lending;macroeconomic stance and the demand side of the bank lending;

– BLENDBLEND - Annual rate of change in bank lending; - Annual rate of change in bank lending;

– BDEPBDEP - Bank deposits as share of GDP; - Bank deposits as share of GDP;

– GRSAVGRSAV – Gross saving rate, annually, as supply side factor of the – Gross saving rate, annually, as supply side factor of the bank lending;bank lending;

– DISCDISC – Discount Rate, as proxy for the supply side of the bank – Discount Rate, as proxy for the supply side of the bank lending; lending;

– SUBLSUBL – Subordinated Loans; – Subordinated Loans;

– TTRADETTRADE - Terms of trade, as proxy of the macroeconomic - Terms of trade, as proxy of the macroeconomic fluctuations; fluctuations;

– DSHOCKDSHOCK - Dummy variable, having a value of 1 in the years - Dummy variable, having a value of 1 in the years when economy was hit by shock, and zero otherwise, as proxy for when economy was hit by shock, and zero otherwise, as proxy for the shock performance;the shock performance;

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ResultsResults

Dependent Variables: CAR (A1); BLEND (A2; A3)Dependent Variables: CAR (A1); BLEND (A2; A3)

Independent Variables:Independent Variables:

tGDP 1tGDP tBDEP 1tBDEP DISR CAR GRSAV TTRADE DSHOCK 2R

A1 -0.03 -0.01 -0.31 0.62 0.04 -0.33 0.55

(0.17) (0.07) (2.34) (4.48) (0.32) (0.38)

A2 1.25 1.40 -0.07 1.42 -20.87 0.68

(1.12) (2.43) (0.15) (1.91) (1.82)

A3 0.99 0.78 -0.02 0.05 0.75 -8.36 0.89

(2.06) (2.61) (0.01) (0.07) (1.85) (1.58)

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Results InterpretationsResults Interpretations

Higher GDP growth rates and positive terms of trade Higher GDP growth rates and positive terms of trade have profound demand effects on lending causing have profound demand effects on lending causing increase in loans where excessively deteriorating increase in loans where excessively deteriorating macroeconomic conditions reduce credit;macroeconomic conditions reduce credit;

Sign of discount rate is positive contrary to the theory Sign of discount rate is positive contrary to the theory where higher the discount rate the lower should be the where higher the discount rate the lower should be the rise in credits;rise in credits;

Increase in lending is accompanied by deteriorating Increase in lending is accompanied by deteriorating capital adequacy ratios;capital adequacy ratios;

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Cont.Cont.

On the other hand, capital ratio moves On the other hand, capital ratio moves antantiicyclically w.r.t. the movement of GDP growth cyclically w.r.t. the movement of GDP growth rate, while at the same time being negatively rate, while at the same time being negatively affected by the macroeconomic shocks;affected by the macroeconomic shocks;

Crucial issue is how banks are achieving higher or Crucial issue is how banks are achieving higher or maintaining the desired level of the CAR by not maintaining the desired level of the CAR by not reducing lending, for example?reducing lending, for example?

CAR level is approached in a residual fashion by CAR level is approached in a residual fashion by the changes in the other parts of the profit the changes in the other parts of the profit function. function.

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Sub-Loans and Bank CapitalSub-Loans and Bank Capital

Iceland: Subordinated Loans and Banking System Capital

1995-97

1920,5 21,7

2,13,5 4,3

0

5

10

15

20

25

1995 1996 1997

ISK

Bn

. Banking System CapitalExcluding SubordinatedLoansSubordinated loans

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Iceland: CAR and Sub-LoansIceland: CAR and Sub-Loans

Iceland: CAR with and without Subrodinated Loans 1995-98

11,1

10,7

9,8

9,8

10

9,2

8,1

7,8

0 5 10 15

1995

1996

1997

1998

Percent

CAR ExcludingSubordinated LoansCAR

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The Impact of the The Impact of the New Basle Capital Adequacy FrameworkNew Basle Capital Adequacy Framework

Points for Discussion:

– Size versus distribution of the CAR;– Procyclicality versus anticyclicality;– Banks behaviour versus CRAs behaviour;

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ConclusionConclusion

CAR is becoming one of the main financial CAR is becoming one of the main financial indicators along with the prevailing market indicators along with the prevailing market conditions that always require certain margin conditions that always require certain margin over the minimum;over the minimum;

If banks should set more capital aside as the risk If banks should set more capital aside as the risk increases, how can one prevent sharp portfolio increases, how can one prevent sharp portfolio reallocations in times of stress?reallocations in times of stress?

CRA´s behaviour will be crucial for the financial CRA´s behaviour will be crucial for the financial stability.stability.