WHAT CAN FINANCIAL REGULATION DO

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• 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

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INTRODUCTION

• Available and stable credit is a wonderful asset
  for a countrys sustained growth
• There is no one single formula as to how to
  achieve it
• I will concentrate exclusively on the role of
  financial regulation

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ROADMAP TO PRESENTATION

• Quick look at evolution of financial regulation
• How can Basel II contribute to stable credit?
• Issues in introducing Basel II
• 4. Conclusions

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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

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2. Basel II and stable credit

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

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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

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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

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2. Basel II and stable credit? (cont)

• The impact on the external cost of capital for
  emerging countries key to assess Basel IIs
  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
• 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

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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

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3. How to introduce Basel II?

• Not single answer
• Depends on the authorities decisions and
  readiness of the financial sector
• Never quick and easy

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Implementing Basel II is a long road for everybody
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But road may be very different and so it should
be!
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3. How to introduce Basel II (cont)
Necessary steps for building a road

• Assessing the current environment
• Making a plan
• Where should the road lead to?
• What kind of road are we building?
• Setting up a project
• What is the time schedule for building the road?
• What is required to build the road to Basel II?
• Testing (and, if need be, improving) the
  foundation
• Constructing the road

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Making a plana. 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

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

• For credit risk
• Simplified standardised approach
• Standardised approach
• Foundation internal ratings-based approach
• Advanced internal ratings-based approach
• For operational risk
• Basic Indicator approach
• Standardised approach
• Alternative standardised approach
• Advanced measurement approaches
• There is not one way to implement Basel II The
  superhighway appears attractive, but traveling at
  high speeds brings great risks!!

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Making a planb. The kind of road will depend on

• Readiness of financial system
• Capitalization, risk awareness, risk management
• 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
• Readiness of regulators and supervisors

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Readiness on regulators side
Basel II framework

• Control over banks structure
• Licensing
• Ownership
• Activities, acquisitions

• Risk management and capital
• Provisioning
• 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

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

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

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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?
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Big banks urge emerging markets to move quickly
but not smaller onesAlso IMF board cautions
against moving too quickly
Only national authorities can know
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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

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

• 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

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

• 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

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• 4. Policy conclusions

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

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• THANK YOU FOR YOUR ATTENTION