A Capital Accord for Emerging Economies?

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A Capital Accord for Emerging Economies?

• Andrew Powell
• Universidad Torcuato Di Tella and
• Visiting Research Fellow, The World Bank
• (Financial Sector Strategy and Policy - FSP)
• July, 2001

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Motivation

• BCBS has published a proposal to change the 1988
  Capital Accord
• The 1988 Accord was perhaps the most successful
  of all financial standards
• Will the New Accord be so successful ?
• Implications for emerging economies
• Cost of capital
• Issues regarding implementing the New Accord
• Acknowledgements, but views strictly my own

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Part 1On the 1988 Accord and the Proposals
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On the 1988 Accord...

• Designed by G10 supervisors and aimed at their
  internationally active banks.
• But, very successful - applied in at least 100
  countries and in many for all banks (Barth,
  Caprio and Levine 2001)
• Easy to criticize such a simple yardstick as
  assets at risk but the simple standard
• Created a type of yardstick competition
• Was adapted to local conditions
• Was easy for legislators to understand

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The New Accord Overview

• The New Accord
• Pillar 1 Requirements
• Pillar 2 Supervisory Review
• Pillar 3 Market Discipline
• Supporting Documents on the above and on
  operational risk, interest rate risk, asset
  securitization etc.

• this presentation focuses on Pillar 1 and within
  that on capital requirements for credit risk.

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Pillar 1 Requirements

• Capital Requirements
• Standardized
• Internal Ratings
• Sovereign, Corporate, Bank, (Retail)
• Enhanced rules for credit risk mitigation
  techniques

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The Standardised Approach
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The Standardized Approachfor Sovereigns

• Survey evidence says banks rely on rating
  agencies.
• Banks have no superior information or are they
  just equally at a loss ?
• There has been a focus on pro-cyclicality
• But up-front provisions already pro-cyclical
• Are banks more pro-cyclical than the agencies?
• But, rating agencies may just get it wrong!
• Very few opinions, assessments subjective but of
  systemic impact (for country).
• And there may be circularity.

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The IRB Approach

• Calibrated on experience with corporate claims
  and applied to Sovereign, Bank and Retail.
• Method draws on advances in risk management in
  large banks.
• Banks must slot claims into Borrower Grades
  (minimum of 6-9 for performing and 2 for
  non-performing)
• Grades mapped into Default Probabilities

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On Model Calibration

• Uses Merton risky debt model, Creditmetricstm
  probability transition matrix and G10 corporate
  default experience.
• Calibrated to cover expected and unanticipated
  losses to 99.5 tolerance value.
• We are told that a 3 year loan with a PD0.7,
  LGD50 and average asset correlation of 20
  gives a risk weight of 100 (i.e. an 8 capital
  requirement).

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Some Maths
BRW Benchmark risk weight, N(.) is cumulative
normal, G(.) is the inverse cumulative normal, PD
is probability of default and LGD is Loss Given
Default. Subsequent adjustments may then be made
for maturity and granularity.
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IRB Approach for Sovereigns

• AAAs As get PD0
• No rules on how many sovereigns in each Borrower
  Grade.
• The remainder of the calibration follows that for
  corporates.

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Part 2On the Cost of Capital forDeveloping
Economies
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Implications of the Proposals

• For IRB approach, Required Capital much more
  sensitive to PD at higher levels of PD.
• This convexity of IRB approach, a consequence
  of credit risk mathematics (not clear how the
  standardized approach is calibrated).
• Perverse incentives for banks ?
• Estimates of effects on spreads

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Source authors calculations based on SP
ratings and BIS consolidated claims on developing
economies and some strong assumptions!
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An alternative IRB Approach for Sovereigns

• Banks must assign an internal rating on a
  Moodys, SP or Fitch type scale
• Capital Requirements are then given by the
  relevant bucket in the standardized approach

? Given the uncertainty of applying the
corporate-calibrated, IRB approach to sovereigns,
this would create a less controversial and less
convex scale.
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Part 3How Emerging Economiesmay implement the
New Accord
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Implementing the New Accord Two important
issues

• Level of Consolidation
• consolidation required to one level above
  internationally active bank
• but many emerging economies have not yet
  implemented consolidated supervision
• Related Lending
• material exposures of more than 15 (individual)
  and 60 (aggregate) deducted from capital

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Standardised versus IRB approach?

• The standardised Approach would lead to little
  change due to the limited universe of rated
  institutions (eg Argentina has about 150 rated
  corporates but there are 25,000 corporates in the
  BCRA credit bureau)
• Or, very sharp rise in demand for ratings and
  potential race to the bottom in terms of rating
  quality.
• The Internal Ratings approaches will be very
  difficult to implement

? Likely result will implement the
standardised approach and little will change
(execpt enhanced rules on collateral and other
supporting documents Pillars 2 and 3 etc.)
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Provisions and Capital

• In Latin America
• some regulators have more legal autonomy to
  determine provisions, capital requirements are
  determined in laws
• provisions do not only reflect ex post
  accounting losses
• level of provisioning often higher than in G10
• in some countries, provisions set through highly
  developed credit bureau policies in attempt to
  reflect expected losses

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More general points regarding model calibration...

• Obvious doubts
• As models are non-linear, difficult to
  re-calibrate to local conditions (not clear what
  11.5 and not 8 means), needs full
  re-calibration
• Not clear whether the correlation of 0.2 nor the
  granularity adjustment are appropriate in
  emerging economies with less diversifiable risk.

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On Minimum Requirements for Internal Rating
Authorisation

• The focus is on a bank developing an internal
  rating system, for that system to satisfy a set
  of minimum requirements and to be integral to the
  banks operations.
• Would give a degree of autonomy in setting
  regulatory capital that many emerging economy
  supervisors may find unacceptable.
• Minimum laid down requirements for the rating
  process may not fit emerging economy data.

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Credit Bureau Policies

• At the same time, some emerging countries have
  developed credit bureau policies. Miller (2000)
  Credit Reporting Systems around the Globe,
  provides a review.
• In 21 of the 30 countries reviewed, there is a
  rating/grade (normally 5 or 6) and in most cases
  this is set by the bank but scrutinised by the
  regulator.
• The objectives have been to improve the
  information in the financial system but in many
  cases the ratings feed directly into provisioning
  requirements.

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The Credit Bureau Policy of the Central Bank of
Argentina

• Started in 1992, gradually increasing in
  coverage, now all loans gt 50, 8 million entries
  per month.
• 5/6 grades 1 and 2 performing, 3-5/6
  non-performing (does not satisfy Basel II).
• Database available for individual inquiries free
  through the internet, all information gt200k and
  good information gt200k sold on a cd
• Corporate gt200k grades forward looking (ex ante),
  retail grade is function of arrears (ex post).
• Feeds directly into provisioning requirements

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Use of Credit Bureau Data to Assess Capital
Requirements

• Anticipated and unanticipated losses two
  statistics from the same distribution
• Can use non-parametric models (eg Carey 2000 and
  Falkenheim and Powell 2000) or parametric models
  (eg Creditmetricstm) or study the probability of
  default from a credit scoring model with a
  parametric model (eg Creditrisktm) to determine
  anticipated and unanticipated losses.
• Central Bank of Argentina has Creditrisktm up
  and running with a preliminary credit scoring
  model.

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Emerging Country Supervisors face a difficult
choice

• Use model results to re-calibrate internal
  ratings approach to local conditions.
• Adapt credit bureau policies to fit minimum
  laid down standards.
• Use existing credit bureau policies as a basis
  for PD estimates.

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Another Alternative is to Develop a Separate
StandardFor Emerging Economies
Autonomy
Flexibility
Simplicity
Complexity
Standardization
Control
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Conclusions

• 1988 Capital Accord was a tremendous success
• The new Accord
• May imply significant increases in the cost of
  funds for lower rated emerging economies.
• Regarding implementation, may be largely
  irrelevant (standardised approach) or difficult
  (IRB) approach.
• The more the New Accord fits risk management
  policies of large international banks, the less
  it may fit most banks in emerging economies
• The time has come to think about a new Accord for
  emerging economies