Regulatory and economic solvency standards for internationally active banks

1

• Regulatory and economic solvency standards for
  internationally active banks
• Comments by
• Giovanni Majnoni
• (The World Bank)
• Basel II An Economic Assessment
• (Basel Committee on Banking Supervision, May
  17-18, 2002)

2
Main points

• The questions addressed and the results
• Comments on methodological questions
• Scope of the analysis and possible extensions.

3
The questions addressed

• The regulatory question
• What level of survival probability is embedded
  in the 8 rule?
• Or what level of bank mortality is acceptable for
  bank regulators?
• The economic question
• What level of survival probability banks
  consider when setting the levels of capital that
  they effectively set aside?
• What justifies prevailing levels of capital.

4
The same questions could be read

• Moving from Basel I to Basel II
• is it realistic the objective of the BCBS of
  keeping at the 8 level the average capital
  requirement in Basel II?
• should we expect a sudden rise or fall of capital
  requirements?
• and for whom?
• how robust are the empirical relationship between
  capital and insolvency levels?

5
The answers of the paper

• For large internationally active banks the 4
  requirement of core capital is coherent with a
  default ratio between 4 (three years horizon,
  average quality portfolio of US banks) and 0.01
  (one year, good quality portfolio)
• The amount of capital held by large G10 banks is
  equal on average to 7 (equivalent to less than
  0,001 default probability over one year
  horizon)
• The market discipline enforce an economic ratio
  larger than the regulatory one
• (Implicitly) switching to a regime that envisages
  similar default frequencies should not have major
  quantitative effects.

6
Methodological contributions

• Simulation procedure for a MTM loan portfolio
  exposed to a common risk factor
• follows a simplified CreditMetrics approach.
• Selects a set of relevant parameters a
  representative portfolio composition, an SP
  transition matrix, an average 50 LGD modeled as
  a beta distribution
• See Carey (2002) for a simulation based on a DM
  approach
• Empirical measurement of the implicit public
  guarantee element built into banks ratings in
  order to assess market evaluation of financial
  strength.

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and a terminology issue

• Confidence interval
• for the paper is the survival probability or
  solvency standard (1-a)
• No other reference to more traditional notion of
  confidence interval
• No measure of the precision of the estimated
  parameters of the loss distribution function
  (mean, percentile levels)
• It is not possible to distinguish whether the
  different default probability levels are
  significantly different among different
  simulations or, alternatively, how many capital
  levels are compatible with one survival
  probability.

8
Confidence intervals

• Confidence intervals (of confidence intervals
  in the paper terminology) grow rapidly as we
  measure percentiles farther away in the tail of a
  distribution
• ?n-1/2 std. error of the sample mean of a
  normal distribution
• k?n-1/2 std. error of a sample percentile (k
  2.13 for the 5 percentile k 3.77 for the 1
  percentile)
• More so for asymmetric distributions (Kupiec,
  1997).
• An incidental remark lack of quantitative
  assessments of general loan loss provisions,
  easier to estimate, especially where data are
  scarce.

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Scope of the analysis and open issues

• What if we consider loan portfolios of banks not
  internationally active? Or if the authors had
  considered transition matrices taken from crisis
  periods (Carey, 2002)?
• When we leave the world of internationally
  active banks an evaluation of the adequate level
  of economic capital and of market discipline
  becomes much harder
• Rating often would not be available
• In emerging economies, when available, ratings
  are almost completely determined by the support
  component (sovereign rating).

10
Scope of the analysis and open issues

• What if the transition matrix looks like the
  following
• Transition matrix for bank loans in Mexico
• Source Lowe and Segoviano (2002)

11
Conclusions

• The paper provides a useful simulation
  methodology to select levels of capital
  requirements
• By concentrating on large international banks
  from G10 countries provides evidence of a market
  discipline tighter than regulatory standards
• Leaves open the question of the latitude of
  market discipline and of the levels of capital
  when we move away from the world of wholesale
  banking.