1. Countercyclical Capital Charges and Currency Dependent Economies Jon Danielsson Asgeir Jonsson April 2005 Jon Danielsson Asgeir Jonsson April 2005 London School of Economics www.RiskResearch.org

2. Currency Dependence  Country can only borrow abroad in foreign currency  Currency risk is held domestically  Emerging markets and small open economies  95% of international bond issues in 5 currencies  We care about the implications not causes  How are these countries affected by Basel-II style regulations  Country can only borrow abroad in foreign currency  Currency risk is held domestically  Emerging markets and small open economies  95% of international bond issues in 5 currencies  We care about the implications not causes  How are these countries affected by Basel-II style regulations

3. Currency Dependence is Procyclical  Banks do foreign capital relending  In booms a cycle between  Exchange rate appreciation pressures  Increased private wealth  Better collateral  Increased demand for loans  Bank profits  Banks do foreign capital relending  In booms a cycle between  Exchange rate appreciation pressures  Increased private wealth  Better collateral  Increased demand for loans  Bank profits

4. Up by the Escalator, Down by the Elevator  In downturns rapid exchange rate depreciation, wealth destruction, credit crunch  The boom is gradual, the crash is rapid and violent  Macro/monetary policy and banking regulations play a direct role in this chain of events  In downturns rapid exchange rate depreciation, wealth destruction, credit crunch  The boom is gradual, the crash is rapid and violent  Macro/monetary policy and banking regulations play a direct role in this chain of events

5. Basel-II and Procyclicality  Risk weighing capital results in procyclicality  Banks have incentives to lend in booms and contract lending in downturns, amplifying the business cycle  Crisis further amplified if banks are constrained by the 8% minimum capital  Risk weighing capital results in procyclicality  Banks have incentives to lend in booms and contract lending in downturns, amplifying the business cycle  Crisis further amplified if banks are constrained by the 8% minimum capital

6. Basel-II, IRB Banks, and Currency Dependence  IRB=Internal ratings based, advanced Basel-II  If currency risk is properly measured, Basel-II should be no more procyclical than in the big currency areas (US, UK, Euro, Japan)  Suppose a bank’s foreign currency assets and liabilities match in amounts and maturities  Is the bank currency hedged? NO  Ignores foreign exchange risk affecting credit risk  IRB=Internal ratings based, advanced Basel-II  If currency risk is properly measured, Basel-II should be no more procyclical than in the big currency areas (US, UK, Euro, Japan)  Suppose a bank’s foreign currency assets and liabilities match in amounts and maturities  Is the bank currency hedged? NO  Ignores foreign exchange risk affecting credit risk

7. Measurement of Market Risk in Basel-I and II  Value–at–Risk (VaR)  One year of historical data (in most cases)  Usually from conditional normal volatility  Exchange rates usually have low volatility  Central Bank may even stabilize exchange rates, thus further lowering volatility, but not risk  But does VaR capture extreme changes in the exchange rate?  Value–at–Risk (VaR)  One year of historical data (in most cases)  Usually from conditional normal volatility  Exchange rates usually have low volatility  Central Bank may even stabilize exchange rates, thus further lowering volatility, but not risk  But does VaR capture extreme changes in the exchange rate?

8. Mexican Peso/USD Returns

9. (In)effectiveness of Monetary policy  Textbook response in booms: raise interest rates, but  this increases wealth and stimulates demand for foreign loans  Contractionary monetary policy may be expansionary  In crisis there is a possibility of a virtual liquidity trap  Textbook response in booms: raise interest rates, but  this increases wealth and stimulates demand for foreign loans  Contractionary monetary policy may be expansionary  In crisis there is a possibility of a virtual liquidity trap

10. Or  The Central Bank could buy the incoming foreign capital  Sterilized  Or nonsterilized  The Central Bank could buy the incoming foreign capital  Sterilized  Or nonsterilized

11. Externalities  If foreign exchange risk is not properly incorporated in banks’ regulatory capital, the banks have incentives to lend excessively in booms, and contract excessively in crisis  One reason is wealth effects  banks  and their borrowers  and even 3 rd parties  If foreign exchange risk is not properly incorporated in banks’ regulatory capital, the banks have incentives to lend excessively in booms, and contract excessively in crisis  One reason is wealth effects  banks  and their borrowers  and even 3 rd parties

12. Summary of Problem  IRB Banks in currency dependent countries engage in excessively procyclical lending  One reason is the relationship between the exchange rate, foreign capital relending, wealth effects  Another is because currency risk is not correctly incorporated into the banks regulatory capital  IRB Banks in currency dependent countries engage in excessively procyclical lending  One reason is the relationship between the exchange rate, foreign capital relending, wealth effects  Another is because currency risk is not correctly incorporated into the banks regulatory capital

13. What to do? 1.measure currency risk correctly: probably impossible 2.or expose banks to currency risk by other means 1.measure currency risk correctly: probably impossible 2.or expose banks to currency risk by other means We can either:

14. Proposal  Capital charges arising from foreign currency lending could be in the same currency, so e.g.  A bank in Poland making a Euro loan of €100, would carry its capital charge from that loan in Euros, i.e. 8% risk weighted of the €100  Capital charges arising from foreign currency lending could be in the same currency, so e.g.  A bank in Poland making a Euro loan of €100, would carry its capital charge from that loan in Euros, i.e. 8% risk weighted of the €100

15. Implications 1.Capital charges from foreign currency loans are countercyclical 2.Monetary policy is more effective 3.Lower currency reserves needed by the Central Bank 1.Capital charges from foreign currency loans are countercyclical 2.Monetary policy is more effective 3.Lower currency reserves needed by the Central Bank