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

ROADMAP TO PRESENTATION 1.Evolution of financial regulation and impact 2.How can Basel II contribute to stable credit? 3.Issues in introducing Basel II 4.Conclusions

1. Evolution of financial regulation and impact Before Basel I, regulation was heterogeneous across countries Basel I was an improvement: –Equal treatment of banks in terms of capital requirements –Reversing ongoing 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 should bring about a number of improvements, such as: 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’) Improvements in the banks’ balance sheet –A larger range of assets can be used as collateral (credit derivatives to some extent and –Treats securitization of riskier assets better than Basel II (i.e.more demand for emerging countries’ assets) –Less incentives to provide short-term lending The Asian crisis shows that excessive short-term lending can be a big drawback –See Basel Committee Working Paper No.2 June 1999

2. Basel II and stable credit (con’t) Better ex-ante measurement of credit quality Not only status but also evolution of credit quality Important to limit unwarranted growth in credit

2. Basel II and stable credit (cont’) Increased prociclicality may be an issue (IMF, 2005 and Persaud, 2000) The final version of the Accord has addressed this concern but hard to tell whether it is enough In any event, not an issue if regulatory capital not binding as is the case in many emerging countries

2. Basel II and stable credit? (cont’) Impact on external cost of capital for emerging countries not necessary bad 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

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

2. Basel II and stable credit? (cont’) Still, increased prociclicality may be an issue (IMF, 2005 and Persaud, 2000) The final version of the Accord has addressed this concern but hard to tell whether it is enough In any event, not an issue if regulatory capital not binding as is the case in many emerging countries

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 plan b. 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 plan b. 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 – Provisioning – Large exposure – Related party exposure – Liquidity Banks’ internal control and governance Account -ing Disclo- sure On-site, off- site monitoring Remedial actions Consolidate d superv Home-host cooperation Basel II framework

Setting up the project a. 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… IIF Steering Committee on Regulatory Capital (Nov 2005) …member banks believe that, as soon as reasonably possible, they and their local jurisdictions should aim to take advantage of … the Internal Ratings Based (IRB) Approaches. …but not smaller ones Also IMF board cautions against moving too quickly… IMF Executive Board (Nov 2005) (The Directors) urged staff to be completely candid when asked to assess countries’ readiness to move to Basel II and to indicate clearly the risks of moving too quickly and too ambitiously. Only national authorities can know

Setting up the project b. 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 project b. 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 project b. 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

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