International Diversification and Bank Capital Requirements

1. International Diversification and Bank Capital Requirements Kevin DavisCommonwealth Bank Chair of FinanceDirector, Melbourne Centre for Financial Studies www.melbournecentre.com.au

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