The New Approach to Financial Regulation: Is it
Relevant for Developing Countries?
(With Applications to Latin America)
LILIANA ROJAS-SUAREZ
February 2011
Motivation
• A lesson from the global financial crisis was that
the existing framework for financial regulation
was (to say the least) inadequate and ineffective
• While a number of proposals are being advanced,
consensus is moving towards a “Macroprudential
Approach”
• A key goal of Macroprudential regulation is to
minimize the macro costs (i.e. output losses) of
financial crises. In a nutshell avoid asset price
bubbles and limit credit crunches
In Principle, the Approach is Extremely Relevant for
Emerging Markets and Other Developing countries.
Credit Booms: Seven-Year Event Window
(Deviation from HP trend Real Credit Per-Capita)
Source: Mendoza and Terrones (2008) Based on 49 episodes in the period 1960-2006
The existing literature shows that credit booms (and busts) in emerging economies
are larger than in industrial countries.
(in the chart, at the peak of the booms, the average expansion in real credit per
capita was almost 30 percent above trend in emerging economies—twice what is
observed in industrial countries.
In Principle, the Approach is Extremely Relevant
for Emerging Markets and Developing Countries
Also:
Output losses and credit crunches are more
severe after lending booms that end up in
crisis, and these costs are larger in developing
countries (Calderon and Serven, 2010)
My Questions
IN PRACTICE:
1. Are the proposals under the macroprudential
approach (including Basel III) relevant for
developing countries?
2. Should the basic concepts of “capital” and
“liquidity” requirements be applied throughout
countries without regards to the degree of
financial development?
3. And (based on 1.and 2.) can the new approach
prevent a financial crisis in developing countries?
From the Old to the New Approach to Regulation
BEFORE THE GLOBAL FINANCIAL CRISIS
Microprudential Regulation
+
- Based on indicators of current health of
individual banks:
•
•
•
•
•
•
Capital
Liquidity
Asset Quality
Profitability
Quality of Board and Management
Sensitivity of Portfolio to Market Risks
Macro Variables (sometimes)
- For stress tests on individual banks and
sometimes on aggregate financial system:
• Economic Growth
• Changes in Terms of Trade
• Volatility of inflation
• International Reserves/Short-term
liabilities
• The fundamental principle of microprudential regulation (and supervision) is
to ensure that risks faced by individual institutions are correctly internalized in
order to avoid moral hazard and minimize the costs to taxpayers from implicit
deposit insurances
• In this framework regulation is constant over time
From the Old to the New Approach to Regulation
AFTER THE CRISIS
Microprudential and Macroprudential Regulation (as complements)
• The goal of macroprudential regulation is to minimize the macro costs of
dealing with financial crises. In a nutshell: to avoid asset price bubbles
and limit credit crunches (in the crisis resolution period)
• The essence of macroprudential regulation is that aggregate risk depends
on the collective action of financial institutions, which varies over time.
Thus, recommendations for macroprudential regulations include:
• Time-varying Regulations
• System-wide regulations to take into account the cross-sectional
distribution of risk
From the Old to the New Approach to Regulation
• Theoretically, in the international academic community:
“We are all macroprudentialists now.” (C. Borio
paraphrasing Friedman)
• In practice: a number of Emerging Market economies
have been macroprudentialists for some time now
• Recurrent deep banking crises and the high resolution costs
involved explain this development
But an important and (yet) unanswered
question is:
• If macroprudential regulation emphasizes
cross-sectional and time differences,
shouldn’t consideration also be given to
huge differences between market depth and
development across countries?
• Could it be that some of the
recommendations of the new approach are
trivial for Emerging Markets while some
others are not relevant?
The New Approach to Regulation: Major
Recommendations on the Table
I. HIGHER QUALITY CAPITAL
• Under the macroprudential approach, only common equity satisfies the requirement for
“high quality” capital. Thus, “Tier 1” capital should be mostly composed of common equity
Why?
•
•
•
•
Under a microprudential view, all that matters is the ratio:
capital
risk-weighted assets
If a bank incurs losses, it needs to restore the ratio, either increasing the numerator or
decreasing the denominator
Under the macroprudential view, it is important to avoid asset contraction; so capital (the
numerator) should be restored (see Hanson, Kashyap and Stein (2010)
If part of capital is formed by stocks “senior” to equity, such as “preferred stock”, it will be
harder for the bank to raise common equity, since investors know that new equity will be
used to “bail out” the position of the more senior preferred investors
The New Approach to Regulation: Major
Recommendations on the Table
I. HIGHER QUALITY CAPITAL
Basel III: Calibration of the Capital Framework
Calibration of the Capital Framework
Capital requirements and buffers (all numbers in percent)
Common Equity (after
deductions)
Tier 1 Capital
Total Capital
Minimum
4.5
6.0
8.0
Conservation Buffer
2.5
Minimum plus conservation buffer
7.0
8.5
10.5
8.5 - 11
10.5 - 13
Countercyclical buffer range*
0 - 2.5
Total
7 - 9.5
* Common equity or other fully loss absorbing capital
Source: Basel Committee on Banking Supervision
Rules to start being implemented in 2013, with full implementation by 2019
I. Higher Quality Capital: Where does Latin
America Stand?
Capital Requirements in Latin America - 2010 (to Q2)
Brazil
Chile
Colombia
Mexico
Peru
Minimum Regulatory Capital to Risk
Weighted Assets
11
10 - 12
9
10
10
Actual Capital to Risk Weighted
Assets
18
13.8
18.1
17
13.5
14.1
10.2
14.3
15
10.5
(in percent, %)
Actual Tier 1 Capital to Risk
Weighted Assets
Source: IMF and National Authorities
• Moreover, in most countries 90% of Tier 1 capital is made up of the highest quality
of capital: “Paid-in capital” + “Accumulated reserves” (formed by compulsory nondistributed profits”
Caution: While a number of LA countries already meet the numerical Basel III
standards, there are remaining issues with respect to accounting standards,
consolidated supervision, risk-management techniques, etc. that weaken the
“economic” value of assets
II. Time-Varying Regulatory Requirements
•
A major criticism of Basel II was its procyclical nature due to
constant capital requirements through the business cycle:
In bad times  bad loans increase  capital declines  credit
contracts to meet requirements  less output growth
•
Also, backward-looking provisioning rules (incurred loss
model), that do not recognize the build-up of credit risks in
“good times” bring about procyclicality. As with capital
requirements, a rise in non-performing loans in “bad times”
calls for increased provisioning and a credit contraction
• Thus, Basel III includes a “countercyclical buffer” with a range of 0 – 2.5 % of common equity. The buffer
will be in effect in periods of excess credit growth and the build up of risk. Basel III also includes a
“conservation buffer” capital requirement, above the minimum requirement. Banks can draw on the buffer
during periods of stress, but the closer banks capital ratios approach the minimum, the greater the constraints
on earnings distribution.
• Also, the Financial Stability Forum (2009) recommended the implementation of dynamic provisioning
II. Time-Varying Regulatory Requirements in
Latin America
•
While countries in Latin America have not yet implemented countercyclical capital
requirements, several countries (Bolivia, Colombia, Peru and Uruguay) already
have dynamic provisioning in place (which could play an equivalent role, given that
loans are the most important asset in Latin American banking systems
•
In Colombia, the implementation of dynamic provisioning on consumer loans in
2008 helped to reduce the excessively rapid expansion of credit. Annual credit
growth, which reached 27% by 2006, declined to 13% by 2008
•
In Peru, where dynamic provisioning responds to changes in GDP growth, the rule
was activated in September 2010, when the average annualized rate of growth of
GDP over the previous 30 months reached 5.86%
While there is not sufficient analysis, this regulatory tool seems appropriate
for Emerging Markets. However, it is subject to some of the accounting
problems mentioned before.
III. Prompt Corrective Action that Requires
Increases in the Value of Capital, not the Ratio
• Prompt Corrective Action (PCA) is an important (and
extremely valuable) component of microprudential
regulation
• A typical characteristic of PCA is early supervisory
intervention (through sanctions and increased monitoring)
for banks whose capital ratios fall below the minimum
requirement
• The contribution of macroprudential regulation is that the
improvement in capital ratios should be done through
increases in the value of capital (again, to contain sharp
credit squeezes)
III. Prompt Corrective Action that Requires Increases in the
Value of Capital, not the Ratio – Latin America is Heading
in the Right Direction
• A number of Latin American countries include PCA in
their banking regulations AND meet the macroprudential
criteria
• Example: Peru’s Banking Law
o When dealing with the requirements that a bank under PCA needs
to meet, to exit the early stages of intervention, the law reads:
“La Empresa debe demonstrar, … una mejora de su posicion, la que
necesariamente debe incluir aportes nuevos de capital en
efectivo.”
“The firm needs to demonstrate, … an improvement in its position
which by necessity has to include new contributions of cash to
increase capital”
IV. Emphasis on “High-Quality Liquidity” and
“Stable Sources of Funding”
• To take into account “contagion effects”, the
macroprudential approach recommends large holdings of
assets that are not prone to fire-sales (that is, don’t lose
liquidity) in “bad states of the world” (that is, in a crisis,
when funding becomes scarce and costly)
• The concern is that in a crisis, financial firms might be
forced to quickly liquidate assets at fire-sale prices, thereby
imposing costs on other institutions holding those same
assets and on collateral values. If the linkages are strong
enough, asset deflation and a credit squeeze would follow
IV. Emphasis on “High-Quality Liquidity” and
“Stable Sources of Funding”
• Thus, the Basel Committee has recommended both a:
1.
Liquidity Coverage Ratio:
stock of high-quality liquid assets
> 100%
Net cash outflows over a 30 day period under
an acute stress scenario
2. Net Stable Funding Ratio:
available amount of stable funding
> 100%
required amount of stable funding
•
Regardless of the formula details and computations, there are two
key issues that are highly relevant for Emerging Markets
o
o
What is “high-quality liquidity” in Emerging Markets?
What is “stable funding” (and therefore, stable deposits) in Emerging
Markets?
IV. “High-Quality Liquidity” and “Stable Sources of
Funding” in Emerging Markets
• The issue of “adequate liquidity” is well-known in Emerging Markets
(both in the private and public sectors)
• Experience shows that banking crises have often been accompanied by
currency crises: a “run on banks” has often been associated with a “run
on the currency” as investors anticipate that large depreciation and/or
inflation will drastically reduce the real value of their locallydenominated wealth
• Even well-structured deposit insurance can not deal with the loss of the
real value of locally-denominated assets in a crisis
For countries, such as those in Emerging Markets, that:
A) Do not issue hard currency, and,
B) Have highly open capital accounts,
“High-quality liquid assets” and “stable sources of funding” are very limited
(The absence of a bank-run in the US and the credibility of its deposit insurance
system, are largely associated with the dollar (still) being the world’s reserve
currency and, thus, the “top-quality” liquid asset)
IV. “High-Quality Liquidity” and “Stable Sources of
Funding” in Emerging Markets
• Among the “high-quality liquid assets” recommended by the
Basel Committee, I attach high value to “claims on or
guaranteed by the IMF, BIS and other multilateral
organizations”, as they can provide the “hard-currency”
insurance needed during crisis episodes
• In this regard, government debt, even if issued in domestic
currency, is often not a “high-quality” liquid asset in many
countries, as they lack deep markets (in some countries, pension
funds provide a stable source of demand for government paper,
but this is due to insufficient options for investment)
• Among stable sources of funding, I favor:
o An estimation of the minimum amount of deposits needed for
transaction purposes (payment system)
o Tier-1 Capital (to the extent that appropriate accounting standards
and consolidated supervision are in place)
V. Treatment of Systemically Important
Financial Institutions
• The macroprudential approach focuses on avoiding the collapse of
markets, not necessarily institutions
o Example: the entire market for asset-backed securities (based on credit
cards, student loans, etc.) collapsed after the Lehman event. This implied a
huge contraction in consumer credit supply
• In this regard, macroprudentialists recommend addressing
vulnerabilities in the financial system as a whole and not just those of
the largest firms
• A key recommendation is to set similar capital requirements for a
given type of credit exposure, regardless of who ultimately holds the
exposure (Hanson et al, 2010). Thus, if a loan is securitized into a
security with tranches, all holders of tranches (hedge funds, brokerdealers, institutional investors, etc.) need to hold capital (post a
margin) against that tranche
• This would prevent regulatory arbitrage
VI. Examples of Systemic non-bank Financial
Activities in Latin America (IMF, 2009)
•
In Jamaica, life insurance companies that offered deposit-like instruments
faced acute liquidity problems in the mid-1990s. The problems spread to
affiliated commercial banks and ended in a huge financial crisis
•
In 2008, non-financial firms in Brazil and Mexico took large speculative
positions in derivatives in the expectation of local currency appreciation.
When these currencies sharply depreciated at the end of 2008, the firms
incurred losses and the central banks had to intervene heavily in their
respective foreign exchange markets
•
Although financial conglomerates operate in many Latin American countries,
consolidated supervision is often weak. This means that the interconnections
among all the affiliates might not be fully understood
•
Investment funds in Brazil and finance companies (SOFOLES) in Mexico are
large and lightly regulated. Mutual funds in Bolivia experienced runs in 2002,
which affected their affiliated commercial banks
In this regard, Latin America and most Emerging Markets
have a long way to go
Systemic Risk from Foreign Banks in Latin America
• Many of the 30 global financial institutions informally identified as
“systemically important” have operations in Latin America:
Percentage of Banking System Assets Held by Systemically Important
Financial Institutions (%)
Argentina
Brazil
Chile
Colombia
Mexico
Peru
22.8
15.3
30.8
16.8
69
27.5
Source: Economist Intelligence Unit and Financial Times
• A recent study (Izquierdo, Galindo, Rojas-Suarez, 2010) shows that
in the presence of an external shock, foreign banks contract credit
growth more than domestic banks. The exception is Spanish banks who
behave like local banks since they fund themselves with local deposits
• Enhancing of cross-border supervision arrangements and
collaboration through supervisory colleges is highly recommended.
Coordination for crisis resolution processes also needs to be considered
A Final Remark to be Emphasized
• Macroprudential regulation cannot be effective
without “The Basics” of regulation, such as:
o Adequate Accounting Frameworks
o Qualified Supervisors
o Independent Judicial Systems
o Political will to implement Norms and Regulations