Countercyclical Capital Charges and Currency Dependent Economies

1. Countercyclical Capital Charges and Currency Dependent Economies Jon Danielsson Asgeir Jonsson April 2005 London School of Economics www.RiskResearch.org

2. Currency Dependence • Country can only borrow abroad in foreign currency • Currency risk is held domestically • Emerging markets and small open economies • 95% of international bond issues in 5 currencies • We care about the implications not causes • How are these countries affected by Basel-II style regulations

3. Currency Dependence is Procyclical • Banks do foreign capital relending • In booms a cycle between • Exchange rate appreciation pressures • Increased private wealth • Better collateral • Increased demand for loans • Bank profits

4. Up by the Escalator, Down by the Elevator • In downturns rapid exchange rate depreciation, wealth destruction, credit crunch • The boom is gradual, the crash is rapid and violent • Macro/monetary policy and banking regulations play a direct role in this chain of events

5. Basel-II and Procyclicality • Risk weighing capital results in procyclicality • Banks have incentives to lend in booms and contract lending in downturns, amplifying the business cycle • Crisis further amplified if banks are constrained by the 8% minimum capital

6. Basel-II, IRB Banks, and Currency Dependence • IRB=Internal ratings based, advanced Basel-II • If currency risk is properly measured, Basel-II should be no more procyclical than in the big currency areas (US, UK, Euro, Japan) • Suppose a bank’s foreign currency assets and liabilities match in amounts and maturities • Is the bank currency hedged? NO • Ignores foreign exchange risk affecting credit risk

7. Measurement of Market Risk in Basel-I and II • Value–at–Risk (VaR) • One year of historical data (in most cases) • Usually from conditional normal volatility • Exchange rates usually have low 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?

8. Mexican Peso/USD Returns

9. (In)effectiveness of Monetary policy • Textbook response in booms: raise interest rates, but • this increases wealth and stimulates demand for foreign loans • Contractionary monetary policy may be expansionary • In crisis there is a possibility of a virtual liquidity trap

10. Or • The Central Bank could buy the incoming foreign capital • Sterilized • Or nonsterilized

11. Externalities • 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 • banks • and their borrowers • and even 3rd parties

12. Summary of Problem • IRB Banks in currency dependent countries engage in excessively procyclical lending • One reason is the relationship between the exchange rate, foreign capital relending, wealth effects • Another is because currency risk is not correctly incorporated into the banks regulatory capital

13. What to do? We can either: • measure currency risk correctly: probably impossible • or expose banks to currency risk by other means

14. 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

15. Implications • Capital charges from foreign currency loans are countercyclical • Monetary policy is more effective • Lower currency reserves needed by the Central Bank