Comments on Panel: Basel II and Emerging Markets

1. Comments on Panel:Basel II and Emerging Markets Liliana Rojas-Suarez Senior Fellow Center for Global Development London School of Economics April 2005

2. What I liked in the papers: • The explicit (or implicit) prioritization of “economic” capital as a guiding tool for banks’ allocation of risk. • The recognition of the role of markets (through Pillar 3 of Basel II) in enhancing banking strength. • Most importantly, there is consensus that Emerging Market countries should not rush into Basel II. • There is recognition about the concerns raised by Emerging Markets, especially those related to: • The potential increase in the procyclicality of capital flows • Potential for competitive problems and distorted playing field, since subsidiaries of foreign banks and local banks might use different capital standards.

3. A comment on Gerd Häusler’s paper While the IMF recognizes concerns raised by Emerging Markets, I view the role of the Fund as “too passive”. For example: • In the standardized approach, Basel II lowers the maturity of interbank loans subject to lower capital charges (preferential treatment). This implies that some foreign banks will have an incentive to shorten the maturity of loans to emerging markets. Since this adversely affects countries’ current efforts to lengthen the maturity structure of foreign liabilities, doesn’t the IMF believe that Basel II might clash with the objective of financial stability? • Improving supervisory practices and implementation of Basel Core Principles is certainly necessary, but what additional policies particular to the features of emerging markets does the IMF recommend?

4. A comment on Jerry Caprio’s paper • Goes to the heart of an important weakness of Basel (I and II), namely the assumption in the Accord that countries have an adequate institutional and political framework. • Makes a strong case regarding the ineffectiveness of government interventions in autocratic political systems. • Rescues the role of Pillar 3 of Basel II. • But in my view, falls short in providing specific recommendation on what emerging markets should do with their existing capital requirements at home.

5. What I missed in the papers: Two related issues: • What is needed for any capital requirement to work in emerging markets given their particular features that distinguish them from industrial countries? • What kind of alternative policies (besides improved supervision and adoption of Basel Core Principles) might be needed in Emerging Markets to effectively improve capital requirements? (Daníelson & Jónsson paper has something to say in this regard)

6. I. What is needed for any capital requirement to work in Emerging Markets Capital requirements have not always constrained risk-taking behavior of banks in many emerging markets In contrast to industrial countries where net real equity decreased before the eruption of a crisis, net real equity growth reached very high levels in the eve of severe banking crises in emerging markets…

7. I. What is needed for any capital requirement to work in Emerging Markets For capital requirements to work as effective indicators of bank strength two sets of conditions must be met: • The well-known condition related to the appropriate accounting, regulatory, supervisory and judicial frameworks. • Capital requirements need to reflect the “true risk” of emerging market bank’s portfolio. And this might be extremely difficult since there are no deep capital markets that validate the quality of reported capital.

8. I. What is needed for any capital requirement to work in Emerging Markets For example, advising Emerging Market countries to continue on Basel I will continue encouraging banks to hold government paper at the expense of private sector loans, as there are no local capital markets that penalize excessive risk taking of banks

9. I. What is needed for any capital requirement to work in Emerging Markets Continuing with the “wrong” pricing of risks in Emerging Markets, especially that of the regulatory treatment of government paper contributes to exacerbate recessions…

10. I. What is needed for any capital requirement to work in Emerging Markets EMBI Spread and Claims on Government as Percentage of total assets of deposit money banks … and weakens the quality of bank assets. For example, previous to their crises, banks in Argentina and Turkey continued to increase their relative holdings of government paper even when the international bond markets had signaled increased “riskiness” for these assets.

11. II. Then, what are adequate alternative or maybe “transitional” policies? In addition to addressing basic weakness in legal, judicial, regulatory and supervisory framework… …In the Transition towards an industrial-country-like capital standard, design a capital standard that appropriately reflects the risks of banks’ assets in emerging markets. That is, modify current capital requirements to: • Initiate risk-based regulations in loan loss provisions (ex-ante provisioning system) • Maintain a simple classification of assets according to risk but drastically modify the risk categories.Two examples: • Appropriate risk assessment of government paper (rather than the zero risk weight used by most emerging markets) • Credit risk distinction between borrowers from tradable and non-tradable sectors.

12. And, therefore, a comment on Daníelson - Jónnson • What the authors call “currency dependence” is known as the problem of “liability dollarization” in emerging markets. • “Exchange rate risk” becomes “credit risk” in economies suffering from liability dollarization (see Rojas-Suárez, 2001). • While the authors’ proposal to denominate capital charges arising from foreign currency lending in the same currency is certainly helpful to deal with the procyclicality issue, it still does not fully take into account two features of emerging markets: • Exchange rate depreciations bring a reduction in the capacity of the non-tradable sector to service its foreign-denominated loans. • Sharp depreciations of the exchange rate are a recurrent feature in these countries. Together, these two factors seem to indicate that ex-ante bank provisioning requirements need to be higher for loans to the non-tradable sector.

13. What else can be done in the near future? • Enhance the mechanisms of market discipline. Lacking deep capital markets to guide supervisors about the “true” value of reported capital, information about the quality of banks’ assets can be obtained through: • Encouraging the offering of uninsured certificate of deposits. • Developing credit bureaus. • Encouraging the development of the inter-bank market.