Basel II and Emerging Markets The Future of Banking Regulation London School of Economics April 7–8, 2005 Gerd Häusler Counsellor and Director International Capital Markets Department

2 Contents 1. IMF Staff View on Basel II 2. Concerns Raised by Emerging Market Countries (EMCs) 3. Basel II and EMC Bank Supervisors 4. Basel II and Banks in EMCs 5. Basel II and Borrowers in EMCs 6. Basel II and Capital Flows to EMCs 7. The Role of the IMF

3 1. IMF Staff View on Basel II Basel II represents a significant improvement over the 1988 Capital Accord (Basel I). Its implementation should enhance financial stability— especially thanks to its focus on risk management. Wide consultative process appreciated implementation date should not take precedence over implementation quality in emerging market countries (EMCs). Supervisory review process is key to successful implementation. Better implementation of Basel Core Principles (BCP) an essential precondition for successful adoption.

4 2. Concerns raised by Emerging Market Countries (EMCs) Complexity of rules. Discretion of time frame. Comparability between institutions—prejudicial to smaller/domestic banks. Weak regulatory framework and lack of resources, leading countries to remain on Basel I. Unfavorable assessments by international financial institutions and international market participants. Increase in EMC banks’ capital. Reduced capital flows to EMCs.

5 3. Basel II and EMC Bank Supervisors Bank supervisors have to choose an appropriate regime: premature adoption of Basel II could create problems, not solutions. For many countries, improving compliance with BCP is a greater and more immediate priority—staying on Basel I over near-term may be a more appropriate option. Identify and monitor competitive implications of chosen approach—while staying on Basel I, leverage interest in Basel II to initiate needed reforms in banking supervision, risk management, and disclosure.

6 3. (cont.) Basel II and EMC Bank Supervisors Develop implementation strategy and road map—2007 is intended for BCBS members; EMC supervisors should be guided by status of their own systems and set timetable accordingly. Build supervisory capacity—recruit and retain qualified staff (huge challenge for supervisors worldwide). Agree on home-host supervisory coordination— understand what international banks are doing in your home market. Facilitate development of common infrastructure, including regional initiatives.

7 4. Basel II and Banks in EMCs Need to strengthen risk management systems—a key competitive tool for banks. Assess effect on capital—prepare action plans for meeting minimum requirements. Anticipate shifts in industry practice and lending behavior. Seek shared solutions. Find the right people and keep them. Local affiliates of international banks: national treatment will likely lead to multiple capital regimes throughout the world. Large domestic banks active internationally: will need to deal with competitive problems if home country stays on Basel I, credibility issues if home country moves to Basel II.

8 5. Basel II and Borrowers in EMCs Basel II and its focus on risk management and risk-sensitive pricing of credit could result in lower borrowing costs for low-risk clients/sectors. Higher-risk borrowers could face rising costs, leading to greater recourse to collateral and credit enhancement. Impetus for developing credit risk mitigation and transfer products.

9 6. Basel II and Capital Flows to EMCs Many major international banks have used economic capital models to price EM credits— unlikely to make many changes under Basel II. Smaller banks, however, may be more influenced by the cost of regulatory capital—Basel II may lead to more risk-sensitive pricing of EM credit. Impact of Basel II on procyclicality of capital flows remains to be seen. However, requirements of IRB calculations of risk parameters over a credit cycle may mitigate the procyclicality risk.

10 7. Role of the IMF Basel II is important to the IMF’s mandate to promote financial stability. The choice of the capital regime is a decision for national authorities. Assessment of capital regimes is but one component of the BCP assessment under FSAP—World Bank/IMF will not assess compliance based on whether or not a country has implemented Basel II. The IMF places more importance on improving supervision and regulation overall (BCP) than on the choice of any particular capital regime. The IMF stands ready to provide technical assistance (TA), along with other TA providers, to lay the foundation for Basel II.