The BIS Regulatory Framework and Icelandic Banking Sector: Issues and Dilemmas

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The BIS Regulatory Framework and Icelandic
Banking SectorIssues and Dilemmas

• Seminar at the Central Bank of Iceland
• February 18, 2002
• Gudmundur Magnusson
• Saso Andonov

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I. The Original (Old) Basle Accord (1988) EU
and EEA (1993)

• Financial stability
• Levelling of the competitive field
• Minimum requirements
• Standardization
• Credit risk
• Simplicity

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II. The Basle Proposals for Market Risk VAR
(1993 and 1995)

• Internal Value at Risk models
• Approval by supervisory authorities
• Trade off between CAR and VAR

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III. The New Basle Accord Proposals

• Still more financial stability
• More differentiated measures of credit risk
• Other types of risk (liquidity, operational,
  legal risk)
• Supervisory review process
• More transparency
• Enhanced market discipline

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IV. Points for Discussion

• Comparison of the New and the Old rules and
  potential implications of the new standards for
  credit risk
• (a) Choice between two alternative approaches
  the standardized approach (SA) and the
  internal ratings based approach (IRBA).
• SA external credit assessment
• IRBA own internal rating of borrowers (two
  options foundation approach or own
  estimates)
• (b) Supervisors could require higher that the
  minimum capital target
• (c) IRBA more risk sensitive good for big banks,
  bad for small?

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Price Structure of Credits With and Without Use
of Credit Models
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Proposals and Practice

• Cost of capital versus risk-adjusted rate of
  return
• Credit risk models in practice
• VaR models, insurance-inspired models,
  Option-based models
• Acceptance by supervisory authorities

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Points for Disscusion cont.

• (d) More average capital needed as a cushion for
  macroeconomic fluctuations?
• (e) Small countries and small banks will suffer?
• (f) Manna from heaven for the rating agencies?

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V. Comprehensive Risk Management on the Banking
Industry Level

• Comprehensive versus narrow scope of banking
• Investment banks and commercial banks
• New types of instruments
• Accounting standards
• Disintegration of banking
• Globalisation
• Lender of last resort
• Regulatory arbitrage

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D.T. Llewellyn Assessing the New Basle Capital
Accord

• Criteria for judging the effectiveness of any
  capital adequacy regime the following twelve
  tests are suggested
• Does it have the effect of aligning the
  regulatory and economic capital?
• Does it create incentives for effective and
  efficient risk analysis, management and control
  mechanisms
• Does it create appropriate incentives for the
  correct pricing of the risk?
• Does it creates incentives for an efficient
  allocation of capital within the bank?

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cont.

• Does it create perverse incentives for regulatory
  arbitrage?
• Does it create unwarranted entry barriers?
• Are the capital requirements competitively
  neutral?
• Are the requirements appropriate for overall
  portfolio risk, as opposed to the sum of project
  risks?
• Does it have the effect of impairing competition
  in banking markets?
• Does it have unfavourable effects on the
  macroeconomy
• Is the new Accord unnecessarily complicated?
• Does it create or reinforce incentives for
  shareholders and other official supervisors to
  monitor the risks of banks and for market
  discipline to be exercised?

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VI. CAR of the Icelandic Banking
System1989-2001
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Second the Alternative One

• Financial Supervisory Authority of Iceland
• "The FSE has also declared that large Icelandic
  credit institutions, even showing an effective
  risk management and internal control, should at
  least aim for a minimum of a 10 CAD ratio. Other
  credit institutions should aim for a higher CAD
  ratio". Annual Report, 2000
• Central Bank of Iceland
• "The capital ratio of the financial institutions
  as a whole has been declining in recent years. At
  the end of 2000 it measured 9.9, down from 10.6
  the previous year. The commercial banks failed to
  reach their target of maintaining capital ratios
  of 10 and above last year". CB of Iceland
  Monetary Bulletin, Financial Stability, 2001,
• International Monetary Fund
• "Decline in Icelandic banks CARs (both including
  and excluding subordinated loans), reflect the
  continued expansion of banks balance sheets
  without a corresponding increase in capital, as
  well as losses sustained on portfolio investments
  as a result of the emerging pressures in the
  domestic and foreign markets". IMF Iceland
  Financial System Stability Assessment

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Third From an International Perspective

• Country 1997 1998
• Denmark 11.61 11.32
• Sweden 13.0 10.8
• Norway 12.6 12.6
• Iceland 9.8 9.1
• Finland 11.9 11.5
• USA 12.8
• Japan 9.1
• Israel 10.5

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VII. Vulnerability and CAR in the Nordic Countries

• Maintaining credible and prudent levels of CAR
  may provide an efficient mechanism in case of
  worsening macroeconomic conditions that may drive
  the system into banking crises
• It is a critical indicator of a disturbance of
  any nature in the bank operational environment
  and will ultimately be reflected in the changes
  of this ratio
• It can serve as an early warning signal
• Point for discussion Would the banking crises in
  the Nordic countries in the early 90s have been
  less adverse if agents had maintained higher than
  the minimum capital standards?
• Is the CAR safe at any speed?

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For Consideration CAR in the Early 90s

• Lesson Safety of the CAR depends both on its
  quality and nature of the environment

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VIII. The Optimal Size of the CAR

• In economic terms, regulatory capital should not
  be increased beyond the point where the marginal
  cost outweighs the expected marginal benefit from
  holding capital
• The most quoted criteria in determining the size
  of the CAR are
• Cost of raising capital
• Economic cycles and their importance for capital
  planning
• Size of the agent and its importance for the
  volatility of the income streams
• Access to liquidity including the Central Bank
• Credibility and peer group pressures

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Modelling the Optimality of CAR

• In our opinion, optimality of the CAR should be
  derived from basic characteristics of the
  economy, both macroeconomic and microeconomic
  ones
• For that purpose, we are proposing four variables
  (or their proxies) to be taken into account when
  determining the desired capital ratio above the
  regulatory minimum
• The policy rule is based on the weighted
  differences or relative differences of the
  variables from matching peers (benchmarks)

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Variable Candidates

• Macroeconomic volatility measure
• Macroeconomic volatility - GDP real growth rate,
  price level, productivity, terms of trade
• Diversification measure
• Sectoral measures - such as loan concentrations
  ratios across sectors
• Overall portfolio measures - such as single
  exposure limits

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continuing

• Microeconomic or banking sector-specific measure
• Capital strength - such as the size and structure
  of the own capital
• Banking-sector specific volatility, such as bank
  deposits, bank credit to the private sector etc
• Profitability measure
• Banking sector efficiency - measured through
  pre-tax profits as single measure or through
  weighted index of net interest income,
  non-interest income, operating expenses and the
  pre-tax profits.

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• Formally
• Hypothesis ?
  ?
• Where
• First term stands for macroeconomic volatility
  effect
• Second for diversification effect
• Third for microeconomic or banking
  sector-specific one and
• Fourth for bank profitability effect.

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• Exposition
• Theoretically dCARa(0.026-0.0098) a0.0152
• where 0.08 is the mandatory capital requirement
• 0.26 is the standard deviation of
  the GDP of Iceland 1989-2000
• 0.0098 is the standard deviation of the OECD
  countries GDP over the same period
• How to determine or calibrate a?
• The value of the parameter a can be treated as
  adjustment parameter of the mandatory minimum and
  it can be derived using cross-country panel data
  estimates
• In a logarithmic multiple regression framework, a
  can be interpreted as an elasticity
• One can also impose additional restrictions to
  different parameters or group of parameters in
  order to determine their relative importance.

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IX. Financial Stability Considerations

• Two-front approach
• Accounting for structural vulnerabilities
• Improving risk management practices.
• Structural vulnerabilities need to be located in
  the main sectors of the economy and assessment to
  be made as to how these can be met with
  corresponding buffers
• Concerning risk management practices, the optimal
  trade-off needs to be found concerning market
  induced vs. regulatory imposed risk management
  practices, both at the banking industry level and
  the individual firm level.

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Structural Vulnerabilities and Buffers
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Market-Based vs. Regulatory-Imposed Risk
Management Practices

• Regulation-Based
• Predominant role of
• FSA power
• Central Bank Regulations
• Accounting and Risk Management Standards
• Other government regulation

• Market-Based
• Predominant role of
• Comprehensive risk
• management practices
• within the banks VS.
• CAR, VAR, Credit Risk Modelling etc
• Banks and MUST
• Credit Rating Agencies Indications
• Transparency of market information and active
  shareholders
• Mandatory rolling-over of certain part of sub
  loans on a secondary market.

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The Early Experience of the Old Basle Capital
Adequacy Framework 1988
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1992
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1996
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Model of Bank Behaviour Under Capital Regulation

• Variable BIS is defined as

L - commercial loans B - bonds D - deposits R
- subordinated debts K - capital C(.) - cost
function of BIS r - interest rates
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Nominator vs. Denominator Changes of the CAR in
G-10

• Number of cases where changes in capital and
  risk-weighted assets contributed positively ()
  or negatively (-) to the change in capital
  adequacy ratio

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Areas of Impact of the Basle Capital Framework

• Impact on Banks Balance Sheets
• Level of Capital Ratios
• Structure of Capital
• Risk-taking Behaviour
• Capital Arbitrage Effects
• Real Sector Effects
• Impact on Net Domestic Credit
• Impact on Output
• Impact on Long-Run Competitiveness of Banks
• Banks vs. Other Credit Institutions
• International Competitiveness Considerations

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Contrasting Empirical Evidence

• In adjusting their balance sheets, banks
  attempted to respond in the least costly way to
  binding capital constraints, depending on the
  cycle and the financial position
• Large and growing capital arbitrage may be
  motivated by other factors, such as taking
  advantages of economies of scale, better
  diversification of funding sources etc
• Changes in bank capital affect lending
• Money matters vs. lending matters for output
  growth
• Evident shift in the funding share by type of
  agents that can not be attributed solely to the
  capital regulation
• Cost of capital matters.

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The Real Meaning of the Capital Adequacy Ratio

• The Fundamental Rule
• Using the Basle model should not mean that the
  system is faithfully copied or not, but whether
  the appropriate adaptations were made to reflect
  local conditions
• Adaptations should be accounted for the risk
  environment
• Ratio analysis should always be complemented by
  qualitative assessment of the banks ability to
  manage its risks

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Other Aspects Deserving Particular Attention

• Reliable market pricing of assets, particularly
  loan portfolio review and assets classification
• Collateral (re)valuation
• Loan loss provisioning and all that
• Interest income recognition policies
• Volatility and deepness of the markets of
  operation

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Iceland Commercial and Savings Banks CAR and the
Risk Profile
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CAR, Macroeconomy and Banking Sector Indicators
Regression Results

• Does CAR reflects the macroeconomic development
  and how macroeconomic shocks are accounted for?
• The impact of CAR on bank lending has Icelandic
  banking sector experienced credit crunch as a
  result of the imposed capital constraint
• Structural dimension of the CAR which parts tend
  to add to the rise/fall in the CAR?

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Variables Included

• GDP - Real GDP growth rage, as proxy for the
  overall macroeconomic stance and the demand side
  of the bank lending
• BLEND - Annual rate of change in bank lending
• BDEP - Bank deposits as share of GDP
• GRSAV Gross saving rate, annually, as supply
  side factor of the bank lending
• DISC Discount Rate, as proxy for the supply
  side of the bank lending
• SUBL Subordinated Loans
• TTRADE - Terms of trade, as proxy of the
  macroeconomic fluctuations
• DSHOCK - Dummy variable, having a value of 1 in
  the years when economy was hit by shock, and zero
  otherwise, as proxy for the shock performance

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Results

• Dependent Variables CAR (A1) BLEND (A2 A3)
• Independent Variables

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Results Interpretations

• Higher GDP growth rates and positive terms of
  trade have profound demand effects on lending
  causing increase in loans where excessively
  deteriorating macroeconomic conditions reduce
  credit
• Sign of discount rate is positive contrary to the
  theory where higher the discount rate the lower
  should be the rise in credits
• Increase in lending is accompanied by
  deteriorating capital adequacy ratios

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Cont.

• On the other hand, capital ratio moves
  anticyclically w.r.t. the movement of GDP growth
  rate, while at the same time being negatively
  affected by the macroeconomic shocks
• Crucial issue is how banks are achieving higher
  or maintaining the desired level of the CAR by
  not reducing lending, for example?
• CAR level is approached in a residual fashion by
  the changes in the other parts of the profit
  function.

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Sub-Loans and Bank Capital
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Iceland CAR and Sub-Loans
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The Impact of the New Basle Capital Adequacy
Framework

• Points for Discussion
• Size versus distribution of the CAR
• Procyclicality versus anticyclicality
• Banks behaviour versus CRAs behaviour

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Conclusion

• CAR is becoming one of the main financial
  indicators along with the prevailing market
  conditions that always require certain margin
  over the minimum
• If banks should set more capital aside as the
  risk increases, how can one prevent sharp
  portfolio reallocations in times of stress?
• CRAs behaviour will be crucial for the financial
  stability.