WHAT CAN FINANCIAL REGULATION DO

TO ENSURE STABLE CREDIT

IN EMERGING COUNTRIES:

Alicia Garcia Herrero

BIS, Representative Office for Asia and the Pacific

Financial Reforms in China an Latin America

Beijing June 7, 2007

INTRODUCTION

Available and stable credit is a wonderful asset for a country’s sustained growth

There is no one single formula as to how to achieve it

I will concentrate exclusively on the role of financial regulation

ROADMAP TO PRESENTATION

1. Quick look at evolution of financial regulation

2. How can Basel II contribute to stable credit?

3. Issues in introducing Basel II

4. Conclusions

1. Evolution of financial regulation

Regulation is a concept of the 1900s, before banks were unregulated

And only from 1988, with Basel I, was regulation harmonized across countries

Basel I achieved:

– Equal treatment of banks in terms of capital requirements

– Reversal of trend towards reduction in capital But still not perfect:

– Not much account of risk Its impact on granting credit is controversial

– Chiuri et al (2002) show a reduction while Barajas, Chami and Cosimano (2005)do not find such evidence

Basel II improves in a number of aspects as compared to Basel I:

1. Better risk measurement and risk management

• The number of firms with a credit rating should increase (specially for standard approach)

• Better understanding of risk:• concept of economic capital• and risk adjusted return on capital

2. Basel II and stable credit

2. Basel II and stable credit? (cont’)

2. Improvements in the banks’ balance sheet

– A larger range of assets can be used as collateral • Corporate bonds, stocks and even credit derivatives

– Securitization fostered more than under Basel I• Particularly so for riskier assets• Probably more demand for emerging countries’ assets)

– Less incentives to provide short-term lending• Relevance of short-term lending as driver of Asian

crisis/Mexican crisis points to contribution of Basel II to provide more stable credit

See Basel Committee Working Paper No.2 June 1999

2. Basel II and stable credit (cont’)

Increased procyclicality may be an issue (IMF, 2005 and Persaud, 2000)

However, the final version of the Accord has addressed this concern in several ways

– Calculating PDs and LGDs for a full cycle and not a certain point in time

– Requesting banks to consider unexpected adverse situations when calculating the capital needs

– Finally, the steepness of the curve relating the capital requirement to the PD has been reduced

In any event, procyclicality of regulatory capital not a big issue if

regulatory capital not binding as is the case in many emerging countries

2. Basel II and stable credit? (cont’) The impact on the external cost of capital for emerging countries

key to assess Basel II’s contribution to providing stable credit

Garcia-Herrero and Santabarbara (2006) conduct an empirical analysis to determine the impact of Basel II on cost of capital for 30 emerging countries

In order to estimate the impact, need to know whether:1. Basel II will be binding (i.e., regulatory capital will be higher than

economic capital derived from internal models) • They find that it will be less binding that Basel I, especially under

IRB

SA IRBBinding 18 14 13Not binding 12 16 17

Basel I Basilea II

2. Basel II and stable credit (cont’)

2. Economic capital – and not the regulatory one- is the key variable for banks to grant financing• Authors estimate model of determinants of economic capital for 30

emerging countries (6 of which Asian)• The cost of capital increases for those with the highest country risk but

falls for many• OECD emerging countries are relatively worse since they lose the OECD

umbrella • Basel I distinguished between OECD and non OECD independently

on the rating but not Basel II

Authors also estimate the impact of regulatory capital on the sovereign spreads and the results are slightly better

País Rating OCDE Basel I SA IRB SA IRBSouth Korea A- Sí No No No 0 0

Hungary A- Sí No Sí Sí 21 12Poland BBB+ Sí No Sí Sí 54 3Mexico BBB- Sí No No No 0 0Turkey B+/BB- Sí No No No 0 0Chile A No Sí No No -43 -43

Malaysia A- No Sí No No -19 -19Thailand BBB/BBB+ No Sí Sí Sí -54 -52

China BBB No Sí Sí Sí -54 -50South Africa BBB No Sí No No -3 -3

Tunisia BBB No Sí No No -11 -11Croacia BBB- No Sí No No -25 -25Bulgaria BB+/BBB- No Sí No No -9 -9

Egypt BB+ No Sí Sí Sí 0 -28El Salvador BB+ No No No No 0 0

Russia BB+ No No No No 0 0Colombia BB No No No No 0 0Marocco BB No Sí Sí No 0 -7Panama BB No No No No 0 0

Philippines BB No No No No 0 0Peru BB-/BB No No No No 0 0Brazil B+/BB- No No No No 0 0

Ukraine B+/BB- No Sí Sí Sí 0 44Pakistan B/B+ No Sí Sí Sí 0 89Indonesia B No Sí Sí Sí 0 94Uruguay B-/B No Sí Sí Sí 0 113

Venezuela B-/B No Sí Sí Sí 0 116Libano B- No Sí Sí Sí 0 130

Domenican Republic CCC No Sí Sí Sí 75 224Ecuador CCC No Sí Sí Sí 75 224

Regulatary capital binding? Change in spreads (b.p.)

3. How to introduce Basel II?

Not single answer

– Depends on the authorities’ decisions and readiness of the financial sector

Never quick and easy

Implementing Basel II is a long road for everybody

But road may be very different and so it should be!

3. How to introduce Basel II (cont’) Necessary steps for building a road

1) Assessing the current environment

2) Making a plan:

a) Where should the road lead to?

b) What kind of road are we building?

3) Setting up a project:

a) What is the time schedule for building the road?

b) What is required to build the road to Basel II?

4) Testing (and, if need be, improving) the foundation

5) Constructing the road

Making a plan:a. Where should the road lead to?

Adequately capitalised banks Better functioning banks in terms of risk assessment

– This should help improve intermediation

Generally a sounder and safer financial system

– Precondition for a stable economy and economic growth

Making a planb. What kind of road are we building? Several approaches

For credit risk

1. Simplified standardised approach

2. Standardised approach

3. Foundation internal ratings-based approach

4. Advanced internal ratings-based approach

For operational risk

1. Basic Indicator approach

2. Standardised approach

3. Alternative standardised approach

4. Advanced measurement approaches

There is not one way to implement Basel II: The superhighway appears attractive, but traveling at high speeds brings great risks!!

Making a planb. The kind of road will depend on:

1. Readiness of financial system

Capitalization, risk awareness, risk management…

2. Readiness of the economy as a whole

Better if not in a boom or in a financial liberalization

process: many opportunities but also many risks

3. Readiness of regulators and supervisors

Readiness on regulators’ side

Preconditions– Sound macro-economic policies– Legal, accounting, auditing and payment systems– Systemic protection

Institutional setting of the supervisor– Independence, governance, accountability, transparency– Resources, legal power

Control over bank’s structure– Licensing– Ownership– Activities,

acquisitions

Risk management and capital– Provisionin

g– Large

exposure– Related

party exposure

– Liquidity

Banks’ internal control and governance

Account-ing

Disclo-sure

On-site, off- site monitoring

Remedial actions

Consolidated superv

Home-host cooperation

Basel II framework

Setting up the projecta. When do we build the road?: Basel II implementation

Basel II Framework (June 2004)

“This document is being circulated to supervisory authorities worldwide with a view to encouraging them to consider adopting this revised Framework at such time as they believe is consistent with their broader supervisory priorities.”

…but how to choose?

Big banks urge emerging markets to move quickly…

…but not smaller onesAlso IMF board cautions against moving too quickly…

Only national authorities can know

Setting up the projectb. What is required to build the road to Basel II?

Implementing Basel II will be a major challenge for banks and supervisors

Assessing resource and training needs

– Human resources

– Financial resources

– Information systems Ongoing communication between supervisors and between

supervisors and banks

Setting up the projectb. What is required to build the road to Basel II? (con’t)

1. A solid foundation is essential for building a road Appropriate infrastructure

– Otherwise there could be a false sense of financial stability

Other regulatory measures should be there

– Risk-based supervision, compliance with core principles, sound accounting and provisioning standards

1988 Accord could be a (temporary) alternative, particularly for small banks

Still, Basel II valuable for supervisors and banks in all markets

Setting up the projectb. What is required to build the road to Basel II? (con’t)

2. Good use of areas of national discretion crucial Recognises countries‘ different realities Facilitates the implementation Allows to take into account domestic market practice and

experience Important to share information with other supervisors

1. In the last two decades, there have been important improvements in regulation Implementing

2. Basel II is an improvement in many ways.

The main challenge for the stable allocation of credit is probably prociclycality, but regulators can take measures through the second pillar

3. As for the implementation of Basel II, regulators can choose their own road according to their financial system and their priorities/constraints

4. Policy conclusions

THANK YOU FOR YOUR ATTENTION