Regulatory and ‘economic’ solvency standards for internationally active banks Comments by



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  • 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

  • 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)?

  • 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:

    • Rating often would not be available;
    • In emerging economies, when available, ratings are almost completely determined by the “support” component (sovereign rating).


Scope of the analysis and open issues

  • What if the transition matrix looks like the following:

  • Transition matrix for bank loans in Mexico

  • Source: Lowe and Segoviano (2002)



Conclusions



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