Regulatory and ‘economic’ solvency standards for internationally active banks Comments by Giovanni Majnoni (The World Bank) Basel II: An Economic Assessment (Basel Committee on Banking Supervision, May 17-18, 2002)

Main points The questions addressed and the results; Comments on methodological questions; Scope of the analysis and possible extensions.

The questions addressed The regulatory question: What level of “survival probability” is embedded in the 8% rule? Or what level of bank mortality is acceptable for bank regulators? The economic question: What level of “survival probability” banks consider when setting the levels of capital that they effectively set aside? What justifies prevailing levels of capital.

The same questions could be read Moving from Basel I to Basel II : is it realistic the objective of the BCBS of keeping at the 8% level the average capital requirement in Basel II? should we expect a sudden rise or fall of capital requirements? …and for whom? how robust are the empirical relationship between capital and insolvency levels?

The answers of the paper For large internationally active banks the 4% requirement of core capital is coherent with a default ratio between 4% (three years horizon, average quality portfolio of US banks) and 0.01% (one year, good quality portfolio); The amount of capital held by large G10 banks is equal on average to 7% (equivalent to less than 0,001% default probability over one year horizon); The market discipline enforce an economic ratio larger than the regulatory one; (Implicitly) switching to a regime that envisages similar default frequencies should not have major quantitative effects.

Methodological contributions Simulation procedure for a MTM loan portfolio exposed to a common risk factor: –follows a simplified CreditMetrics approach. –Selects a set of relevant parameters: a representative portfolio composition, an S&P transition matrix, an average 50% LGD modeled as a beta distribution; –See Carey (2002) for a simulation based on a DM approach; Empirical measurement of the “implicit public guarantee” element built into banks ratings in order to assess “market” evaluation of financial strength.

…and a terminology issue Confidence interval: for the paper is the “survival probability” or “solvency standard” (1-a); No other reference to more traditional notion of “confidence interval”: –No measure of the precision of the estimated parameters of the loss distribution function (mean, percentile levels); –It is not possible to distinguish whether the different default probability levels are significantly different among different simulations or, alternatively, how many capital levels are compatible with one “survival probability”.

Confidence intervals Confidence intervals (of “confidence intervals” in the paper terminology) grow rapidly as we measure percentiles farther away in the tail of a distribution : –  n -1/2 = std. error of the sample mean of a normal distribution; –k  n -1/2 = std. error of a sample percentile (k= 2.13 for the 5% percentile; k= 3.77 for the 1% percentile); –More so for asymmetric distributions (Kupiec, 1997). An incidental remark: lack of quantitative assessments of general loan loss provisions, easier to estimate, especially where data are scarce.

Scope of the analysis and open issues 1.What if we consider loan portfolios of banks not internationally active? Or if the authors had considered transition matrices taken from crisis periods (Carey, 2002)? 2.When we leave the world of “internationally active banks” an evaluation of the adequate level of economic capital and of market discipline becomes much harder: 1.Rating often would not be available; 2.In emerging economies, when available, ratings are almost completely determined by the “support” component (sovereign rating).

Scope of the analysis and open issues 1.What if the transition matrix looks like the following: Transition matrix for bank loans in Mexico Source: Lowe and Segoviano (2002) ABCDE A B C D E

Conclusions The paper provides a useful simulation methodology to select levels of capital requirements; By concentrating on large international banks from G10 countries provides evidence of a market discipline tighter than regulatory standards; Leaves open the question of the latitude of market discipline and of the levels of capital when we move away from the world of wholesale banking.