The Basle Committee of G-10 banking regulators
has proposed a new Capital Accord, with the expressed aim of more accurately
aligning regulatory capital with the risks that international banks face.
Recent detailed research shows clearly that the current Basle proposal
would quite significantly overestimate the risk of international bank
lending to developing countries; this would increase capital requirements
excessively on such lending, leading to a sharp increase in the cost of
bank borrowing by developing countries, as well as to an important fall
in the supply of bank loans.
This is particularly serious issue now, as in the last five years bank
lending to the developing world has already fallen sharply. This decline
in bank lending and other capital flows has had a very negative impact
on growth in the developing world, especially recently in Latin America.
Thus, the current proposals are problematic, both in terms of the Basle
Committee's own aims (more accurate measurement of risk for determining
capital adequacy) and due to their further discouragement of already insufficient
bank lending to emerging markets, which damages growth of their economies.
The latter impact is manifestly against one of the aims of the G-10, which
is actively to encourage private flows to developing countries and use
them as an engine for stimulating and funding growth.
How do the current Basle proposals overestimate
risk of lending to developing countries? How could they be modified to
be both more precise and less damaging to developing countries?
One of the reported major benefits of lending to –and investing
in – developing countries, is their relatively low correlation with
mature markets. In our research, we have carefully tested this hypothesis
empirically and found very strong evidence – for a variety of variables,
and over a range of time periods – that correlation between developed
and developing countries is significantly lower than correlation only
amongst developed countries. For example, spreads on syndicated loans
– which reflect risks and probability of default – tend to
rise and fall together within developed regions more than between developed
and developing countries; similar results are obtained for the correlation
of profitability of banks. Furthermore, broader macro-economic variables
(such as growth of GDP, interest rates, evolution of bond prices and stock
market indexes) show far more correlation within developed economies than
between developed and developing ones.
Finance theory and practice tells us that the clear implication of these
empirical findings is that a bank's loan portfolio that is diversified
between developed and developing countries has a lower level of risk,
than one focussed exclusively on lending to developed economies. In order
to test this more directly we simulated two loan portfolios, one with
diversification only across developed economies, and another that diversified
across developed and developing regions. We found that the estimated unexpected
losses for the portfolio focussed only on developed country borrowers
was almost 23% higher.
Reflecting risk
Given that the capital requirements which Basel regulators determine should
precisely help banks cope with unexpected losses, it is extremely unfortunate
that the current Basle proposals do not incorporate explicitly the benefits
of international diversification. The surprising fact that at present
the Basle proposal does not do so implies that in this aspect, capital
requirements will not clearly reflect risk, and thus will be both incorrectly
and unfairly penalising lending to developing countries.
It therefore seems imperative that the Basle Committee in its next (and
almost final) revision of the proposed Basel II, incorporates the benefits
of international diversification, for example by explicitly reducing capital
requirements, to take account of these diversification benefits.
Lending to small and medium enterprises
It is encouraging that there is a clear precedent, as the Basle Committee
has already made such a change with respect to lending to small and medium
enterprises (SME's). After the release of the consultative document in
January 2001, there was widespread concern – especially in Germany
– that the increase in capital requirements would sharply reduce
bank lending to SMEs, with very negative effects on growth and employment.
The technical case was made that the probability of a large number of
SMEs defaulting simultaneously was lower than for a smaller group of large
borrowers. Intensive lobbying by the German authorities implied that this
technical argument was recognised, and the Basel Committee agreed to lower
average capital requirements by about 10% for smaller companies.
Our empirical research implies that at least as large a modification is
justified with respect to international diversification, related to lending
to developing countries. There are no practical, empirical or theoretical
obstacles to such a change, which could potentially greatly benefit the
developing world and ensure more precise measurement of risk and capital
adequacy requirements. This, after all, is the aim of the entire process.
Recognising the benefits of international diversification
The Basle Committee has always emphasised the technical nature of its
proposals and the technical case for including the benefits of diversification
is extremely strong. Furthermore, G-10 governments have a strong commitment
to encouraging private flows, and therefore an incentive to avoid measures
being taken that actually discourage such flows. Developing and transition
countries are unfortunately not represented at all in the Basle Committee,
so they have limited leverage to make the case. However, given the Basle
Committee's technical expertise and fair-mindedness, hopefully a change
will be introduced to the current proposal, to take account of the benefits
of international diversification. It would be technically wrong, economically
unwise and politically insensitive not to do so.