1 International Diversification and Bank Capital Requirements Kevin Davis Commonwealth Bank Chair of Finance Director, Melbourne Centre for Financial Studies

2 The Issues Does international diversification by banks reduce risk of bank failure (for a given level of capital)? If so, does Basel 2 give adequate recognition to this in determination of regulatory capital requirements? If not, what are the consequences? –For credit markets –For future development of multinational banking What, if anything, should be done?

3 The Increasing Importance of International Bank Diversification Example: Increased Foreign Bank role in emerging markets Central/Eastern Europe –Minimal in 1990, 80+% of bank assets in 2004 Asia (excluding Singapore/ Hong Kong) –Minimal in 1990, most increase (to 20% of bank assets in Malaysia and Thailand –Singapore / HK substantial, but has declined Latin America –Minimal in 1990, increased to around 40% Source: Domanski (BIS Quarterly Review (Dec 2005)

4 Benefits of International Diversification Lower correlation of individual asset returns across economies than within economy Should translate into lower correlation of default probabilities –If so, lower economic capital required for internationally diversified portfolio of loans than for similar domestic portfolio –Basel 2 regulatory capital - no such distinction

5 Digression But note, international diversification isn’t just about risk – also about export of skills to exploit competitive advantages Regulatory approaches focused on prudential supervision and risk management need to ensure that benefits from the potential export of skills aren’t threatened

6 International v Domestic Diversification Are there benefits for credit risk? For equities, the funds management world recognises specific country/regional equity funds as different asset classes Country specific private credit risk portfolios should therefore also be seen as separate asset classes –Even ignoring sovereign/country risk –Default risk is “backed out” from corporate asset value behavior which also drives equity values What holds in equity markets also holds for credit Basel 2 implicitly assumes one asset class

7 International v Domestic Diversification Does nature of international diversification matter for credit risk and bank failure concerns? –International banking (cross border lending) v multinational banking –Legal structures (branch v subsidiary) for multinational banking –Range and nature of countries involved in a bank’s diversification –Synthetic international diversification (credit derivatives, CDO’s) Different characteristics are probably more relevant to operational and strategic risk, and potential for wrong pricing, than credit risk –But they are relevant for nature and number of interactions with regulators (home/host) Basel 2 (Pillar 1) makes no distinctions in determining aggregate regulatory capital

8 Diversification & Capital Needs A Key Feature of Pillar One RegCap(A+B) = RegCap(A) + RegCap(B) –Basel 2 allows for a prescribed correlation in calculating regulatory capital for each individual loan –Capital requirement independent of rest of portfolio True for Standardised approach as well as IRB In contrast EcCap(A+B) < EcCap(A) + EcCap(B) –Actual correlations generate lower economic capital for portfolio versus stand-alone measurement –Allocation of economic capital gain from diversification is problematic Particularly across international boundaries

9 Benefits of Basel 2 Approach “Simple” set of general rules applicable to all banks for calculating risk-weight and capital requirement Applicable in multiple regulator, multinational banking, cases –Pillar One regulatory capital for subsidiary in host country independent of home country parent situation branch in host country independent of host country characteristics –Pillar Two can be used by home and host country supervisors as required

10 Issues with Basel 2 Approach In principle, Basel 2 may be calibrated such that –RegCap(A+B) = EcCap(A+B) where A and B are different country portfolios ie, average risk weights reflect international, as well as domestic, correlations –Unlikely –But this still leaves potential divergences between bank and regulatory allocation of capital across countries. And…

11 Issues with Basel 2 Approach Dealing with multiple minimum regulatory capital requirements due to subsidiaries creates costs Banks will want to maintain a buffer of capital above regulatory minimum to avoid incurring penalty costs from breaching minimum –Buffer size depends on regulatory approach (eg prompt corrective action v forbearance) Unless capital can be quickly and costlessly transferred between subsidiaries –Total buffer capital will be higher

12 Issues with Basel 2 Approach Underlying model may not fit a multi-country world –One factor (global business cycle) model used Resulting correlations are independent of country –For example, implies same correlation between asset values of two similar US firms as between similar US and Indian firms –Economic capital models should allow for differences due to imperfect correlation of national business cycles How correlated are national business cycles? Increased due to economic integration and prevalence of global shocks, but…

13 Correlations: Increasing but not perfect Source: Jansen and Stokman, European Central Bank Working Paper 401, Dec 2004

14 Issues with Basel 2 Approach With a one factor model approach, it must be calibrated such that capital requirements are, at best, either –Appropriate for internationally diversified portfolios, but too low for non-diversified portfolios, or –Too high for internationally diversified portfolios, but appropriate for non-diversified portfolios More likely to be the latter

15 Possible Implications If regulatory capital doesn’t reflect international diversification benefits then…. –Implicit objective of aligning regulatory and bank internal “best practice” risk and capital management not being achieved –Regulatory capital “excessive” for banks with significant international diversification –But banks still receive some benefit as long as the capital market recognises lower failure risk and if this is priced into the cost of a bank’s equity capital. –Banks may seek benefits of international diversification through synthetic means rather than establishing operations and facing compliance requirements of host regulators However,

16 Competitive Advantage Banks expand internationally to exploit their knowledge capital and other bank specific assets Expansion into foreign markets may involve (realistic) expectations of high profits Basel 2 focus on negative tail of expected loss distribution ignores mean of expected profit distribution –For example, if bank can set prices to achieve expected profit (return on assets) of, say, 2% p.a. should this trend increase in capital be taken into account in setting regulatory capital requirements –Conversely, if losses expected in start up years…

17 Conclusions Basel 2 doesn’t appear to adequately reflect risk diversification benefits from international diversification –regardless of whether it is achieved by multinational banking expansion or other means Dealing with multiple minimum capital requirements of host regulators imposes a cost in the form of a higher “buffer” of capital –This may encourage synthetic international diversification, unless specific skills and comparative advantage easily transferred across national boundaries