Download Countercyclical Capital Charges and Currency Dependent Economies

Basel II and Monetary
Policy in Small Open
Economies
Ásgeir Jónsson
Jón Daníelsson
May 2005
The outline
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B.
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E.
F.
Basel II and Procyclicality
Basel II and Monetary Policy
Currency dependence
The exchange rate externality
Monetary policy in currency dependent
economies.
Proposals
Basel II and pro-cyclicality
Basel II and Pro-cyclicality
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One of the central changes proposed by the new Basel II
regulatory framework is the concept of internal-rating-based
(IRB) capital requirements.
Under the IRB approach, regulatory capital will be a function
of the estimated credit risk.
Estimated credit risk is taken to be a predetermined function
of four parameters: probability of default (PD), loss given
default, exposure at default, and maturity.
Banks operating under the “Advanced” variant of the IRB
approach will be responsible for providing all four of these
parameters, based on their own internal models.
Banks operating under the “Foundation” variant of the IRB
approach will be responsible only for providing the PD
parameter, with the other three parameters to be set
externally by the Basel committee.
Basel II and Procyclicality
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Most discussions of bank capital regulation start from the
premise of keeping the probability of bank default below
some fixed target level.
 It is common to speak of, say, a 99.90 percent confidence
level, which means that the bank has only a 0.10 percent
probability of default over the next year.
 Once this target level is set, one can use information on the
bank’s portfolio—along with various other assumptions—to
figure out how much capital it will take to achieve the target.
See e.g. Gordy (2003).
 This Basel II approach can be summarized in terms of a
single “risk curve,” which relates the capital charge for any
given loan to the risk attributes of that loan, such as its
probability of default.
Basel II and capital charges
Basel II and Pro-cyclicality
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However, in a downturn the banks' capital base is likely
being eroded by loan losses.
 Its existing (non-defaulted) borrowers will be downgraded by
the relevant credit-risk models, forcing the bank to hold more
capital against its current loan portfolio.
 It is invariably difficult or costly for banks to raise fresh
external capital in bad times, which will force them to cut
back on its lending activity, thereby contributing to a
worsening of the initial downturn.
 Thus, the new Basel II regulatory framework is likely to have
pro-cyclical effects which can lead to over-lending in booms
and underinvestment during recessions.
Basel II and Procyclicality
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As with any form of regulation, the case for regulating bank
capital presumably rests on some sort of market failure, or
externality.
In this case, the externality is that bank failures have systemic
costs that are not fully borne by the bank in question.
These systemic costs include losses absorbed by government
deposit insurance, disruptions to other players in the financial
system etc..
Thus, the regulator’s task is to somehow get the bank to
internalize these systemic costs.
However, a social planner might not only think about bank
defaults per se.
She should also think about the efficiency of bank lending, that
loans with a positive net present value are still to be made in
recession.
Application to the small open
economy
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If currency risk is properly hedged or measured Basel-II
should be no more pro-cyclical for small open economies
than in the big currency areas
However, even though banks' foreign currency assets and
liabilities match in amounts and maturities it does not
mean that the currency risk has been hedged.
Movements in the exchange rate have a direct effect on
the burden of debt of currency linked loans and are a thus
a major factor for credit risk assessment.
Since movements in the exchange rate are pro-cyclical,
the application of Basel II with regard to credit risk is likely
to be more pro-cyclical in small open economies carrying
currency linked debt.
Application to the small open
economy
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How should currency risk be estimated?
 Measurement of Market Risk in Basel-I and II is
based on Value–at–Risk (VaR) methods
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Exchange rates usually have low volatility
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One year of historical data (in most cases)
Usually from conditional normal 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?
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Basel II and Monetary Policy
Basel II and monetary policy
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The consensus is slowly emerging that Basel capital
adequacy rules (both I and II) can have substantial
effect on the transmission of monetary policy.
This is due to the failure of the Miller-Modigliani
theorem for banks, the banks' lending decisions are not
independent of their financial structure.
Two channels
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The lending channel
The Bank Capital channel
For early work on "Credit Crunch" associated with
Basel I, see Bernanke and Lowe (2002).
The Bank lending channel
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The banks cannot expand lending without an corresponding
equity to comply with the capital adequacy requirements.
New equity cannot be issued during downturns and the CAD
constraints can become increasingly binding for new loans.
At the extreme, the capital constraints become binding (e.g.
At the 8% target level) and the lending channel shuts down.
This has been named "virtual liquidy trap" see Jónsson and
Daníelsson (2004)
There is no inter-bank market for bank equity and therefore it
is not only the average capital that matters but also its
distribution among the banks.
The Bank Capital channel
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In reality, most banks are not at the capital constraint at any
given time. However, the risk of breaching the constraint is
very real.
 Van den Heuvel (2001, 2002) has shown in a model
calibrated with U.S. data that a low-capital bank may
optimally forgo profitable lending opportunities in order to
lower the risk of future capital inadequacy.
 The level of bank capital may thus have a substantial effect
on the transmission of monetary policy.
 A tighter monetary policy and higher interest rates will
reduce future profits of the banks, however the effect on
lending will be dependent on the capitalization of the
banking system.
The exchange rate externality
Currency Dependence
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About 98% of international bond issues are in
just 5 currencies (Euro, Dollar, Pound, Yen and
Swiss Franc)
Countries outside these currency areas, needing
to draw international funds, have to borrow in
foreign currency.
This applies to Less Developed Economies, New
Market Economies, Emerging Market
Economies, as well as developed small open
economies.
In these countries, domestic residents hold
foreign or currency linked debt, usually obtained
through the domestic banking system.
We term this as currency dependence
Related concepts
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Liability dollarization and Debt Intolerance
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Original Sin
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Applies to the pre-dominance of foreign debt in emerging
market economies and the inability handle the overall debt
which would seem quite manageable by the standard of
developed economies. See Reinhart, Rogoff and Savastano
(2003)
Applies to the inability of a country to borrow abroad in
domestic currency, causes of which has argued to be
"secondary market liquidity premium in currency
markets. See Eichengreen, Hausman and Panizza
(2003).
Currency mismatches
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Applies to the "sensitivity of net worth or of the present
value of net income to changes in the exchange rate"
increasing the cost of crisis in the event of a large
depreciation of the currency. See e.g. Goldstein and
Turner (2004)
The Exchange rate externality
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In currency dependent economies, foreign currency
lending on the behalf of domestic banks improves the
capital margin of other banks, including banks who do
not engage in foreign currency lending
The inflow of foreign currency and appreciating exchange
rate causes the value of assets and foreign debt
denominated in domestic currency (both the banks and
the counterparties), to move in opposite directions.
This creates an externality or external wealth effect for
the financial system.
The Bank Wealth effect
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An exchange rate appreciation will…
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3.
…reduce the value of foreign items on the banks' balance
sheet and boost its equity ratio since it is denominated in
domestic currency. Thus, the capital charges arising from
foreign currency lending are lowered.
...reduce the burden of foreign debt and improves the credit
risk of banks' loan portfolio. Thus, the risk weighted capital
charges are lowered.
...improve the net asset position of the wider economy,
increasing money demand and boosting creation of sight
deposit (M1) which is cheapest source of domestic financing
for the banks. Thus, the average cost of domestic financing is
reduced in the banking system
The Client Wealth effect
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An exchange rate appreciation will benefit those
carrying unhedged currency risk whose booked value
of foreign debt will be reduced.
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Greater collateral, net of debt, rises, improving their risk
rating, and increasing demand for new loans.
Greater wealth, as well as lower import prices, will stimulate
aggregate demand and improve economic fundamentals.
These two wealth effects are mutually reinforcing,
increasing demand for domestic assets, including
domestic currency, leading to a further currency
appreciation
The feed back effects of
exchange rate appreciation
Moreover,…
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Foreign loans are usually taken in order to invest or
purchase some assets.
 Therefore, the acceleration of foreign re-lending
usually corresponds to higher asset prices which will
increase banks´ profits as well as the income of their
clients.
 In many currency dependent economies, large
increase in bank equity have preceded banking crisis.
 Foreign currency lending can create a virtuous cycle
of demand for domestic currency and domestic
assets, and appreciation of the exchange rate.
The feed back effects of
exchange rate appreciation
Up by the escalator
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Similarly, a depreciation will have a negative wealth effect, but at
a much faster rate, a phenomena described by the “up by the
stairs, down by the elevator” principle.
The currency appreciation and wealth creation is usually
gradual, and the depreciation and wealth destruction fast and
violent.
As the net asset position is increased, and the economy heats
up, an increasing number of informed agents build up an
expectation of a currency depreciation.
Nobody wants to be the last to hedge their currency positions,
and a large number of agents may attempt to reverse their
positions simultaneously.
As the result, the exchange rate fall very drastically as the as
domestic agents try to hedge their currency risk by aquiring
foreign assets and/or selling domestic assets.
Down by the Elevator
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The boom is gradual, the crash is rapid and
violent.
 Rapid exchange rate depreciation causes the
value of debts and assets to move in opposite
directions, leading to wealth destruction and
credit crunch.
 See e.g. Kaminsky & Reinhart (2000) on the
stylized facts of the twin crisis, how a collapse
in the exchange rate leads a banking crisis in
6-12 months.
Monetary policy in currency
dependent economies
Weak interest rate pass-through
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An inflation targeting central bank can be successful in the short–
term, while at the same time its contractionary policy interventions
may not only pass–by but actively encourage growing imbalances
in the financial sector.
Borio and White (2004), maintain that episodes of financial
instability with serious macroeconomic costs have been more
frequent in recent times of price stability, than when inflation was
more prevalent, both in developed and emerging markets.
This suggests that financial and price stability objectives may be in
conflict with each other, the so-called“paradox of credibility”. Borio
and Lowe (2002), Borio and White (2004) and Goodfriend (2003).
Monetary policy in CDEs is especially challenging because of the
importance of the exchange rate.
The duality of the exchange rate with the respect to monetary
policy and financial regulation may be the cause of a conflict
between price and financial stability.
(In)effectiveness of Monetary
policy
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For currency dependent economies in a boom, interest rate
increases may have the perverse effect of stimulating the
economy in the short-run.
 Higher interest rates increase spread between foreign and
domestic loans, increases the attractiveness of foreign
lending,
 The resulting exchange rate appreciation creates positive
wealth effects which may stimulate aggregate demand as
well as asset markets.
 At least, contractionary monetary policy, might do little to
constrain banks that are experiencing rapid improvements of
their equity position and lower capital charges.
(In)effectiveness of Monetary
policy
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Similarly, an expansionary policy in times of crisis is
likely to backfire with a further depreciation of the
exchange rate and wealth destruction.
In fact, policy responses to currency and bank crisis in
currency dependent economies have invariably been
procyclical. E.g. in the Asian crisis, Chile, etc.
Authorities are forced to respond to negative shocks
with a monetary contraction and higher interest rates to
shore up the exchange rate against a massive outflow
of foreign currency.
They even have to inject new bank capital into the
system or take over failed banks in order to prevent a
collapse of the financial system.
Proposals
Summary of Problem
 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
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banks
and their borrowers
and even 3rd parties
What to do?
We can either:
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2.
measure currency risk correctly: probably
impossible
or expose banks to currency risk by other
means
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
Implications
1.
Capital charges are relatively
countercyclical,
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because the internalization of currency risk into the capital margin
of banks, reduces the capital ratio and increases the capital cost
of foreign currency lending in times of booming asset markets,
and lessens the severity of loan contraction during crisis
1.
Monetary policy is more effective,
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since interest rate changes have a direct relationship
with the level of banking activity, via the impact on
bank capital due to exchange rate changes
1.
Lower currency reserves needed by the CB,
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since the central bank can keep lower levels of currency reserves,
because it does not need to sterilize inflows due to foreign
currency lending, nor maintain as high a cushion for times of crisis
The ratio of currency linked loans out total
loan portfolio in the Icelandic banking system
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