Countercyclical Capital Charges and Currency Dependent Economies

Countercyclical Capital Charges and Currency Dependent Economies

Jon DanielssonAsgeir Jonsson

April 2005

Jon DanielssonAsgeir Jonsson

April 2005

London School of Economicswww.RiskResearch.org

Currency DependenceCurrency Dependence

Country can only borrow abroad in foreign currency

Currency risk is held domestically Emerging markets and small open

economies 95% of international bond issues in 5

currencies We care about the implications not causes

How are these countries affected by Basel-II style regulations

Country can only borrow abroad in foreign currency

Currency risk is held domestically Emerging markets and small open

economies 95% of international bond issues in 5

currencies We care about the implications not causes

How are these countries affected by Basel-II style regulations

Currency Dependence is Procyclical

Currency Dependence is Procyclical

Banks do foreign capital relending In booms a cycle between

Exchange rate appreciation pressures Increased private wealth Better collateral Increased demand for loans Bank profits

Banks do foreign capital relending In booms a cycle between

Exchange rate appreciation pressures Increased private wealth Better collateral Increased demand for loans Bank profits

Up by the Escalator, Down by the Elevator

Up by the Escalator, Down by the Elevator

In downturns rapid exchange rate depreciation, wealth destruction, credit crunch

The boom is gradual, the crash is rapid and violent

Macro/monetary policy and banking regulations play a direct role in this chain of events

In downturns rapid exchange rate depreciation, wealth destruction, credit crunch

The boom is gradual, the crash is rapid and violent

Macro/monetary policy and banking regulations play a direct role in this chain of events

Basel-II and ProcyclicalityBasel-II and Procyclicality

Risk weighing capital results in procyclicality Banks have incentives to lend in booms

and contract lending in downturns, amplifying the business cycle

Crisis further amplified if banks are constrained by the 8% minimum capital

Risk weighing capital results in procyclicality Banks have incentives to lend in booms

and contract lending in downturns, amplifying the business cycle

Crisis further amplified if banks are constrained by the 8% minimum capital

Basel-II, IRB Banks, and Currency DependenceBasel-II, IRB Banks, and Currency Dependence

IRB=Internal ratings based, advanced Basel-II

If currency risk is properly measured, Basel-II should be no more procyclical than in the big currency areas (US, UK, Euro, Japan)

Suppose a bank’s foreign currency assets and liabilities match in amounts and maturities Is the bank currency hedged? NO Ignores foreign exchange risk affecting credit

risk

IRB=Internal ratings based, advanced Basel-II

If currency risk is properly measured, Basel-II should be no more procyclical than in the big currency areas (US, UK, Euro, Japan)

Suppose a bank’s foreign currency assets and liabilities match in amounts and maturities Is the bank currency hedged? NO Ignores foreign exchange risk affecting credit

risk

Measurement of Market Risk in Basel-I and II

Measurement of Market Risk in Basel-I and II

Value–at–Risk (VaR) One year of historical data (in most cases) Usually from conditional normal volatility

Exchange rates usually have low volatility Central Bank may even stabilize exchange

rates, thus further lowering volatility, but not risk

But does VaR capture extreme changes in the exchange rate?

Value–at–Risk (VaR) One year of historical data (in most cases) Usually from conditional normal volatility

Exchange rates usually have low volatility Central Bank may even stabilize exchange

rates, thus further lowering volatility, but not risk

But does VaR capture extreme changes in the exchange rate?

Mexican Peso/USD ReturnsMexican Peso/USD Returns

-20%

-10%

0%

10%

20%

30%

Dec

93

Feb

94

Apr

94

Jun

94

Aug

94

Oct

94

Dec

94

Feb

95

Apr

95

Jun

95

Aug

95

-20%

-10%

0%

10%

20%

30%

Dec

93

Feb

94

Apr

94

Jun

94

Aug

94

Oct

94

Dec

94

Feb

95

Apr

95

Jun

95

Aug

95

(In)effectiveness of Monetary policy

(In)effectiveness of Monetary policy

Textbook response in booms: raise interest rates, but

this increases wealth and stimulates demand for foreign loans

Contractionary monetary policy may be expansionary

In crisis there is a possibility of a virtual liquidity trap

Textbook response in booms: raise interest rates, but

this increases wealth and stimulates demand for foreign loans

Contractionary monetary policy may be expansionary

In crisis there is a possibility of a virtual liquidity trap

OrOr

The Central Bank could buy the incoming foreign capital Sterilized Or nonsterilized

The Central Bank could buy the incoming foreign capital Sterilized Or nonsterilized

ExternalitiesExternalities

If foreign exchange risk is not properly incorporated in banks’ regulatory capital, the banks have incentives to lend excessively in booms, and contract excessively in crisis

One reason is wealth effects banks and their borrowers and even 3rd parties

If foreign exchange risk is not properly incorporated in banks’ regulatory capital, the banks have incentives to lend excessively in booms, and contract excessively in crisis

One reason is wealth effects banks and their borrowers and even 3rd parties

Summary of ProblemSummary of Problem

IRB Banks in currency dependent countries engage in excessively procyclical lending

One reason is the relationship between the exchange rate, foreign capital relending, wealth effects

Another is because currency risk is not correctly incorporated into the banks regulatory capital

IRB Banks in currency dependent countries engage in excessively procyclical lending

One reason is the relationship between the exchange rate, foreign capital relending, wealth effects

Another is because currency risk is not correctly incorporated into the banks regulatory capital

What to do?What to do?

1. measure currency risk correctly: probably impossible

2. or expose banks to currency risk by other means

1. measure currency risk correctly: probably impossible

2. or expose banks to currency risk by other means

We can either:

ProposalProposal

Capital charges arising from foreign currency lending could be in the same currency, so e.g.

A bank in Poland making a Euro loan of €100, would carry its capital charge from that loan in Euros, i.e. 8% risk weighted of the €100

Capital charges arising from foreign currency lending could be in the same currency, so e.g.

A bank in Poland making a Euro loan of €100, would carry its capital charge from that loan in Euros, i.e. 8% risk weighted of the €100

ImplicationsImplications

1. Capital charges from foreign currency loans are countercyclical

2. Monetary policy is more effective3. Lower currency reserves needed

by the Central Bank

1. Capital charges from foreign currency loans are countercyclical

2. Monetary policy is more effective3. Lower currency reserves needed

by the Central Bank