A Capital Accord for Emerging Economies?

Andrew PowellUniversidad Torcuato Di Tella and

Visiting Research Fellow, The World Bank

(Financial Sector Strategy and Policy - FSP)

July, 2001

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

Part 1:

On the 1988 Accord and the Proposals

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

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.

Pillar 1: Requirements

• Capital Requirements– Standardized– Internal Ratings

• Sovereign, Corporate, Bank, (Retail)

• Enhanced rules for credit risk mitigation techniques

Table 1: Risk Weights Given External Credit Ratings Basel Committee on Banking Supervision

January 2001

AAA to A+ to BBB+ to BB+ to Below UnratedAA- A- BBB- B- B-

Sovereign 0% 20% 50% 100% 150% 100%

Bank Alternative 1 20% 50% 100% 100% 150% 100%Bank

Alternative 2a 20% 20% 20% 50% 150% 20%

AAA to A+ to BBB+ to Below UnratedAA- A- BB- BB-

Corporate 20% 50% 100% 150% 100%

a: refers to rating of bank and not to rating of sovereign, for claims of less than 3 months

lent and funded in local currency.

The Standardised Approach

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.

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

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 PD=0.7%, LGD=50% and average asset correlation of 20% gives a risk weight of 100% (i.e.: an 8% capital requirement).

44.0

)1(*0470.01*)288.1)(*118.1(*5.976)(PD

PDPDGNPDBRWC

Some Maths…

LGDPDBRWLGD

MinRW cc *5.12),(*50

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’.

IRB Approach for Sovereigns

• AAA’s – A’s get PD=0• No rules on how many sovereigns in each

Borrower Grade.• The remainder of the calibration follows

that for corporates.

Part 2

On the Cost of Capital forDeveloping Economies

Ratings and Capital Requirements(from Powell 2001, 'A Capital Accord for Emerging Countries?)

0.03% 0.03% 0.03%

0.2%

1.4%

15.0%

6.6%

0

5

10

15

20

25

30

35

40

45

50

AAA AA A BBB BB B CCC

Ratings

% C

apita

l Req

uire

men

ts

Current Requirements Standardized Internal Ratings

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…

E s ti mated E ff ec ts on I nter es t R ates

(as s umes f undi ng c os t of 5%, r equi r ed r etur n on equi ty of 18%)

-200. 00

-100. 00

0. 00

100. 00

200. 00

300. 00

400. 00

500. 00

600. 00

700. 00

AAA AA A BBB BB B CCC

R at in g

Standardised Approach I nternal Ratings Approach

Source: author’s calculations based on S&P ratings and BIS consolidated claims on developing economies and some strong assumptions!

Estimated Effects on Capital RequirementsFor BIS Reporting Banks Lending to Developing Countries

Rating Number of BIS Consolidated Change in Cap. RequirementsCountries Liabilities Standardized IRB

$bn

AAA 1 100.1 -79.1% -85.2%AA 1 28.5 -97.2% -98.0%A 11 193.6 -62.6% -79.9%BBB 16 186.3 -18.7% 3.7%BB 14 178.6 6.8% 112.5%B 17 228.2 10.5% 380.7%CCC 1 1.6 59.3% 524.5%

Total Excl Mexico and Korea 1028.4 -17.6% 90.5% Below BBB 408.4 9.1% 261.8%Total Incl Mexico and Korea 1150.9 -5.6% 110.1% Below BBB 33 530.9 36.7% 305.4%

Effect on Average Cost of Funds for Developing Countries(Assuming Cost of Equity of BIS Reporting Banks=18% and Cost of Funds 5%)

-100

0

100

200

300

400

500

600

700

BBB BB B CCC Below BBB ExclMexico

Below BBB InclMexico

Basis

Po

ints

Standardized IRB

An alternative IRB Approach for Sovereigns

• Banks must assign an ‘internal’ rating on a Moody’s, S&P 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.

Part 3:

How Emerging Economiesmay implement the New Accord

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

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.)

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

Graph 1: The credit loss distribution:anticipated vs unanticipated losses, provisions vs capital

0 2500 5000 7500 10000 12500 15000 17500 20000 22500 25000 27500

Credit Loss ($)

Pro

babi

lity

Provisions = Expected Loss

Capital Requirements = Unexpected Loss

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.

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 bank’s 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.

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.

The Credit Bureau Policy of the Central Bank of Argentina

• Started in 1992, gradually increasing in coverage, now all loans > $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 >$200k and ‘good’ information >$200k ‘sold’ on a cd

• Corporate >200k grades forward looking (ex ante), retail grade is function of arrears (ex post).

• Feeds directly into provisioning requirements

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: Creditrisk+tm) to determine anticipated and unanticipated losses.

• Central Bank of Argentina has Creditrisk+tm up and running with a preliminary credit scoring model.

Probability of Loss Distribution for the Credit Portfolio of the Five Largest Argentine Private Banks

0.000000%

0.000005%

0.000010%

0.000015%

0.000020%

0.000025%

0.000030%

0.000035%

0.000040%

0.000045%

0.000050%

0 2000000 4000000 6000000 8000000 10000000 12000000 14000000

Loss (In thousands)

Sigma = 0.50 Mu

Sigma = 0.30 Mu

U ( L o ss ) = 0 .3 0 = 3 ,5 0 9 ,1 5 1

E (L o ss) = 0 .3 0 = 2 ,9 6 5 ,2 8 1

E ( L o s s ) = 0 .5 0 = 2 ,9 6 3 ,5 2 1

U (L o ss) = 0 .5 0 = 6 ,6 7 7 ,4 2 2

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.

Another Alternative is to Develop a Separate Standard

For Emerging Economies

Simplicity Complexity

Autonomy

Control

Flexibility

Standardization

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