Piroska M. Nagy EBRD

1. Basel II’s Impact in the Emerging European Markets 15th International Banking Congress Saint Petersburg, June 7-10, 2006 Piroska M. Nagy EBRD

2. Outline of presentation • Basel II update • Impact of Basel II • The EBRD’s role

3. Basel II timeline • Basel II is designed for large internationally active banks, but it will spread more widely: • Compulsory in the EU;adopted by the European Parliament. Implementation from Jan 1, 2007 • Will be introduced in many advanced economies: Canada, Japan, Switzerland, Singapore, Hong Kong, Australia • Delay in the USA: 2009 instead of 2008, and only the most sophisticated method allowed. They will modify Basel I for the other banks • Peer pressure will accelerate its introduction in other EMs (Asia, Latin America). In transition economies: Croatia, Albania, other SEEs; Kazakhstan, Russia.

4. Basel II will be introduced in stages in many countries • Full introduction of simple and more sophisticated approaches: Australia, Korea, Singapore, New Zealand, EU • First Standardized Approach only, but in a year the Internal-Ratings Based approach: Hong Kong, Japan, Thailand • Only Standardized Approach for the time being and later move to advanced ones at a date not yet known: China, India

5. Basel II Pillar 1: Minimum capital requirement Pillar 2: Supervisory review of capital Pillar 3: Market discipline ■More risk-sensitive approaches ■Risk assessment is a bank responsibility ■Disclosure requirements used as instrument of “peer pressure” ■ Banks can choose their approach -supervisors to approve ■Supervisors to review banks’ calculations and strategy ■Banks to disclose information on data and modelling ■More recognition of credit risk mitigation ■Bank should hold more capital than the minimum required ■ Banks using more advanced methods have to disclose more ■New capital charge for operational risk ■Supervisors can levy additional capital charge operational risk Basel II in one picture …

6. Impact of Basel II On : • Regulatory capital • Bank behaviour • Industry competition and consolidation • Macro economy • Special issues in CEEs

7. Impact of Basel II – Capital: the biggest question Individual/regional Global

8. Hungary – QIS3 and QIS5 outcomes TOTAL Op risk Credit risk TOTAL

9. Summary • Advanced economies: capital requirement of banks with good risk management and reasonable portfolios will decline • Emerging Markets the results will be very diverse Winners: • Banks that can afford expensive models and IT • Banks that improve their risk management and database  Start early with the preparations! • Banks with large retail exposures – the winning asset class of Basel II Losers: • Banks with weak portfolio and risk management quality • Banks whose lending is concentrated on low or non-rated corporates and sub-investment grade sovereigns • Banks that delay preparations

10. Impact on bank behaviour • Big improvement inrisk management. In emerging markets, it is a “mini-revolution” • Better risk management will help better pricing of credit risk by business line • Use of risk mitigation instruments is expected to jump • Possible portfolio shakeouts • Results clearly depend on the type of approach chosen

11. Impact on banking industry Further bank consolidation can be expected • Dispersion is large (remember the Hungarian case) – clear winners and losers • Large banks have an edge because only they can afford best IT and models. The result will be freed-up capital for expansion • Medium-sized and small banks without a clear niche may be targeted • In Central and Eastern Europe and also in Russia, ongoing bank consolidation may get a boost from Basel II

12. Impact on macro economy • Probably positive on growth: better pricing  better capital allocation  higher potential growth • Procyclicality: big debate, but probably increases procyclicality • Some concerns over systemic risks (home-host; boost to already high household debt)

13. Special issues in emerging Europe • In many countries where main banks are foreign-owned, the Basel II process is parent bank-controlled • Non-foreign owned, local banks face huge challenges in complying with Basel II • Supervisory preparedness is an additional challenge

14. The Home-Host Supervisory Issue • Basel II’s approach: supervision is based on consolidated banking group • Thus, home supervisor takes the lead in supervision and monitoring, and in coordinating with host supervisor • Problem: if a country’s banking system is dominated by foreign-owned banks/their subsidiaries, host supervisors lose power while still are responsible by law for financial sector stability There should information-sharing but also perhaps cost-burden sharing

15. Special Issue: Basel II provides for more mitigation & higher level of protection Level of protection Basel II Higher Capital Relief Basel I Range of CRM instruments

16. What are these CRMs? Well-known in advanced economies but not yet in Emerging Europe • Credit Risk Mitigation instruments • Guarantees • Credit derivatives • Securitization • Netting operations • Collateralization • For many of these, banks will need high- quality credit enhancers such as the EBRD • For many of these, some legal and regulatory adjustments may be needed

17. Why is the EBRD interested in all this? • EBRD has a mandate to promote financial sector development and Basel II is the new industry standard • Basel II essentially leverages the regulatory system to improve risk management in banks and EBRD supports this • Basel II gives incentives for developing capital market products – exactly what is missing to complete “transition” in the financial sector

18. What can the EBRD do? • Help develop better risk management practices • As part of this, work with banks to introduce properly designed risk mitigation instruments (primarily securitization, some simple credit derivatives) • Provide credit enhancement • Help address potential need for higher regulatory capital • Work with regulators to modify the legal and tax framework.

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