Basel II and Monetary Basel II and Monetary Policy in Small Open Policy in Small Open

EconomiesEconomies

Ásgeir Jónsson Ásgeir Jónsson Jón DaníelssonJón Daníelsson

May 2005May 2005

The outlineThe outline

A.A. Basel II and ProcyclicalityBasel II and ProcyclicalityB.B. Basel II and Monetary PolicyBasel II and Monetary PolicyC.C. Currency dependenceCurrency dependenceD.D. The exchange rate externalityThe exchange rate externalityE.E. Monetary policy in currency dependent Monetary policy in currency dependent

economieseconomies..F.F. ProposalsProposals

Basel II and pro-cyclicalityBasel II and pro-cyclicality

Basel II and Pro-cyclicalityBasel II and Pro-cyclicality One of the central changes proposed by the new Basel II One of the central changes proposed by the new Basel II

regulatory framework is the concept of internal-rating-based regulatory framework is the concept of internal-rating-based (IRB) capital requirements.(IRB) capital requirements.

Under the IRB approach, regulatory capital will be a function Under the IRB approach, regulatory capital will be a function of the estimated credit risk. of the estimated credit risk.

Estimated credit risk is taken to be a predetermined function Estimated credit risk is taken to be a predetermined function of four parameters: probability of default (PD), loss given of four parameters: probability of default (PD), loss given default, exposure at default, and maturity. default, exposure at default, and maturity.

Banks operating under the “Advanced” variant of the IRB Banks operating under the “Advanced” variant of the IRB approach will be responsible for providing all four of these approach will be responsible for providing all four of these parameters, based on their own internal models.parameters, based on their own internal models.

Banks operating under the “Foundation” variant of the IRB Banks operating under the “Foundation” variant of the IRB approach will be responsible only for providing the PD approach will be responsible only for providing the PD parameter, with the other three parameters to be set parameter, with the other three parameters to be set externally by the Basel committee.externally by the Basel committee.

Basel II and ProcyclicalityBasel II and Procyclicality Most discussions of bank capital regulation start from the Most discussions of bank capital regulation start from the

premise of keeping the probability of bank default below premise of keeping the probability of bank default below some fixed target level. some fixed target level.

It is common to speak of, say, a 99.90 percent confidence It is common to speak of, say, a 99.90 percent confidence level, which means that the bank has only a 0.10 percent level, which means that the bank has only a 0.10 percent probability of default over the next year. probability of default over the next year.

Once this target level is set, one can use information on the Once this target level is set, one can use information on the bank’s portfolio—along with various other assumptions—to bank’s portfolio—along with various other assumptions—to figure out how much capital it will take to achieve the target. figure out how much capital it will take to achieve the target. See e.g. Gordy (2003). See e.g. Gordy (2003).

This Basel II approach can be summarized in terms of a This Basel II approach can be summarized in terms of a single “risk curve,” which relates the capital charge for any single “risk curve,” which relates the capital charge for any given loan to the risk attributes of that loan, such as its given loan to the risk attributes of that loan, such as its probability of default.probability of default.

Basel II and capital chargesBasel II and capital charges

Basel II and Pro-cyclicalityBasel II and Pro-cyclicality However, in a downturn the banks' capital base is likely However, in a downturn the banks' capital base is likely

being eroded by loan losses.being eroded by loan losses. Its existing (non-defaulted) borrowers will be downgraded by Its existing (non-defaulted) borrowers will be downgraded by

the relevant credit-risk models, forcing the bank to hold more the relevant credit-risk models, forcing the bank to hold more capital against its current loan portfolio. capital against its current loan portfolio.

It is invariably difficult or costly for banks to raise fresh It is invariably difficult or costly for banks to raise fresh external capital in bad times, which will force them to cut external capital in bad times, which will force them to cut back on its lending activity, thereby contributing to a back on its lending activity, thereby contributing to a worsening of the initial downturn.worsening of the initial downturn.

Thus, the Thus, the new Basel II regulatory framework is likely to have new Basel II regulatory framework is likely to have pro-cyclical effects which can lead to over-lending in booms pro-cyclical effects which can lead to over-lending in booms and underinvestment during recessions. and underinvestment during recessions.

Basel II and ProcyclicalityBasel II and Procyclicality

As with any form of regulation, the case for regulating bank As with any form of regulation, the case for regulating bank capital presumably rests on some sort of market failure, or capital presumably rests on some sort of market failure, or externality. externality.

In this case, the externality is that bank failures have systemic In this case, the externality is that bank failures have systemic costs that are not fully borne by the bank in question. costs that are not fully borne by the bank in question.

These systemic costs include losses absorbed by government These systemic costs include losses absorbed by government deposit insurance, disruptions to other players in the financial deposit insurance, disruptions to other players in the financial system etc.. system etc..

Thus, the regulator’s task is to somehow get the bank to Thus, the regulator’s task is to somehow get the bank to internalize these systemic costs. internalize these systemic costs.

However, a social planner might not only think about bank However, a social planner might not only think about bank defaults per se.defaults per se.

She should also think about the efficiency of bank lending, that She should also think about the efficiency of bank lending, that loans with a positive net present value are still to be made in loans with a positive net present value are still to be made in recession.recession.

Application to the small open Application to the small open economyeconomy

If currency risk is properly hedged or measured Basel-II If currency risk is properly hedged or measured Basel-II should be no more pro-cyclical for small open economies should be no more pro-cyclical for small open economies than in the big currency areasthan in the big currency areas

However, even though banks' foreign currency assets and However, even though banks' foreign currency assets and liabilities match in amounts and maturities it does not liabilities match in amounts and maturities it does not mean that the currency risk has been hedged. mean that the currency risk has been hedged.

Movements in the exchange rate have a direct effect on Movements in the exchange rate have a direct effect on the burden of debt of currency linked loans and are a thus the burden of debt of currency linked loans and are a thus a major factor for credit risk assessment.a major factor for credit risk assessment.

Since movements in the exchange rate are pro-cyclical, Since movements in the exchange rate are pro-cyclical, the application of Basel II with regard to credit risk is likely the application of Basel II with regard to credit risk is likely to be more pro-cyclical in small open economies carrying to be more pro-cyclical in small open economies carrying currency linked debt. currency linked debt.

Application to the small open Application to the small open economyeconomy

How should currency risk be estimated?How should currency risk be estimated? Measurement of Market Risk in Basel-I and II is Measurement of Market Risk in Basel-I and II is

based on Value–at–Risk (VaR) methodsbased on Value–at–Risk (VaR) methods One year of historical data (in most cases)One year of historical data (in most cases) Usually from conditional normal volatilityUsually from conditional normal volatility

Exchange rates usually have low volatilityExchange rates usually have low volatility Central Bank may even stabilize exchange rates, thus further Central Bank may even stabilize exchange rates, thus further

lowering volatility, but not risklowering volatility, but not risk

But does VaR capture extreme changes in the But does VaR capture extreme changes in the exchange rate? exchange rate?

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Basel II and Monetary PolicyBasel II and Monetary Policy

Basel II and monetary policyBasel II and monetary policy The consensus is slowly emerging that Basel capital The consensus is slowly emerging that Basel capital

adequacy rules (both I and II) can have substantial adequacy rules (both I and II) can have substantial effect on the transmission of monetary policy. effect on the transmission of monetary policy.

This is due to the failure of the Miller-Modigliani This is due to the failure of the Miller-Modigliani theorem for banks, the banks' lending decisions are not theorem for banks, the banks' lending decisions are not independent of their financial structure.independent of their financial structure.

Two channelsTwo channels• The lending channelThe lending channel• The Bank Capital channelThe Bank Capital channel

For early work on "Credit Crunch" associated with For early work on "Credit Crunch" associated with Basel I, see Bernanke and Lowe (2002). Basel I, see Bernanke and Lowe (2002).

The Bank lending channelThe Bank lending channel The banks cannot expand lending without an corresponding The banks cannot expand lending without an corresponding

equity to comply with the capital adequacy requirements.equity to comply with the capital adequacy requirements. New equity cannot be issued during downturns and the CAD New equity cannot be issued during downturns and the CAD

constraints can become increasingly binding for new loans.constraints can become increasingly binding for new loans. At the extreme, the capital constraints become binding (e.g. At the extreme, the capital constraints become binding (e.g.

At the 8% target level) and the lending channel shuts down.At the 8% target level) and the lending channel shuts down. This has been named "virtual liquidy trap" see Jónsson and This has been named "virtual liquidy trap" see Jónsson and

Daníelsson (2004) Daníelsson (2004) There is no inter-bank market for bank equity and therefore it There is no inter-bank market for bank equity and therefore it

is not only the average capital that matters but also its is not only the average capital that matters but also its distribution among the banks.distribution among the banks.

The Bank Capital channelThe Bank Capital channel In reality, most banks are not at the capital constraint at any In reality, most banks are not at the capital constraint at any

given time. However, the risk of breaching the constraint is given time. However, the risk of breaching the constraint is very real.very real.

Van den Heuvel (2001, 2002) has shown in a model Van den Heuvel (2001, 2002) has shown in a model calibrated with U.S. data thatcalibrated with U.S. data that a low-capital bank may a low-capital bank may optimally forgo profitable lending opportunities in order to optimally forgo profitable lending opportunities in order to lower the risk of future capital inadequacy.lower the risk of future capital inadequacy.

The level of bank capital may thus have a substantial effect The level of bank capital may thus have a substantial effect on the transmission of monetary policy.on the transmission of monetary policy.

A tighter monetary policy and higher interest rates will A tighter monetary policy and higher interest rates will reduce future profits of the banks, however the effect on reduce future profits of the banks, however the effect on lending will be dependent on the capitalization of the lending will be dependent on the capitalization of the banking system. banking system.

The exchange rate externalityThe exchange rate externality

Currency DependenceCurrency Dependence About 98% of international bond issues are in About 98% of international bond issues are in

just 5 currencies (Euro, Dollar, Pound, Yen and just 5 currencies (Euro, Dollar, Pound, Yen and Swiss Franc) Swiss Franc)

Countries outside these currency areas, needing Countries outside these currency areas, needing to draw international funds, have to borrow in to draw international funds, have to borrow in foreign currency.foreign currency.

This applies to Less Developed Economies, New This applies to Less Developed Economies, New Market Economies, Emerging Market Market Economies, Emerging Market Economies, as well as developed small open Economies, as well as developed small open economies.economies.

In these countries, domestic residents hold In these countries, domestic residents hold foreign or currency linked debt, usually obtained foreign or currency linked debt, usually obtained through the domestic banking system. through the domestic banking system.

We term this as currency dependenceWe term this as currency dependence

Related conceptsRelated concepts Liability dollarization and Debt IntoleranceLiability dollarization and Debt Intolerance

Applies to the pre-dominance of foreign debt in emerging Applies to the pre-dominance of foreign debt in emerging market economies and the inability handle the overall debt market economies and the inability handle the overall debt which would seem quite manageable by the standard of which would seem quite manageable by the standard of developed economies. See Reinhart, Rogoff and Savastano developed economies. See Reinhart, Rogoff and Savastano (2003)(2003)

Original SinOriginal Sin Applies to the inability of a country to borrow abroad in Applies to the inability of a country to borrow abroad in

domestic currency, causes of which has argued to be domestic currency, causes of which has argued to be "secondary market liquidity premium in currency "secondary market liquidity premium in currency markets. See Eichengreen, Hausman and Panizza markets. See Eichengreen, Hausman and Panizza (2003).(2003).

Currency mismatchesCurrency mismatches Applies to the "sensitivity of net worth or of the present Applies to the "sensitivity of net worth or of the present

value of net income to changes in the exchange rate" value of net income to changes in the exchange rate" increasing the cost of crisis in the event of a large increasing the cost of crisis in the event of a large depreciation of the currency. See e.g. Goldstein and depreciation of the currency. See e.g. Goldstein and Turner (2004)Turner (2004)

The Exchange rate externalityThe Exchange rate externality In currency dependent economies, foreign currency In currency dependent economies, foreign currency

lending on the behalf of domestic banks lending on the behalf of domestic banks improves the improves the capital margin of other banks, including banks who do not capital margin of other banks, including banks who do not engage in foreign currency lendingengage in foreign currency lending

The inflow of foreign currency and appreciating exchange The inflow of foreign currency and appreciating exchange rate causes the value of assets and foreign debt rate causes the value of assets and foreign debt denominated in domestic currency (both the banks and denominated in domestic currency (both the banks and the counterparties), to move in opposite directions. the counterparties), to move in opposite directions.

This This creates an externality or external wealth effect for creates an externality or external wealth effect for the financial system. the financial system.

The Bank Wealth effectThe Bank Wealth effect An exchange rate appreciation will…An exchange rate appreciation will…

1.1. ……reduce the value of foreign items on the banks' balance reduce the value of foreign items on the banks' balance sheet and boost its equity ratio since it is denominated in sheet and boost its equity ratio since it is denominated in domestic currency. Thus, the capital charges arising from domestic currency. Thus, the capital charges arising from foreign currency lending are lowered. foreign currency lending are lowered.

2.2. ...reduce the burden of foreign debt and improves the credit ...reduce the burden of foreign debt and improves the credit risk of banks' loan portfolio. Thus, the risk weighted capital risk of banks' loan portfolio. Thus, the risk weighted capital charges are lowered.charges are lowered.

3.3. ...improve the net asset position of the wider economy, ...improve the net asset position of the wider economy, increasing money demand and boosting creation of sight increasing money demand and boosting creation of sight deposit (M1) which is cheapest source of domestic financing deposit (M1) which is cheapest source of domestic financing for the banks. Thus, the average cost of domestic financing for the banks. Thus, the average cost of domestic financing is reduced in the banking systemis reduced in the banking system

The Client Wealth effectThe Client Wealth effect

An exchange rate appreciation will benefit those An exchange rate appreciation will benefit those carrying unhedged currency risk whose booked value carrying unhedged currency risk whose booked value of foreign debt will be reduced.of foreign debt will be reduced.

Greater collateral, net of debt, rises, improving their risk Greater collateral, net of debt, rises, improving their risk rating, and increasing demand for new loans.rating, and increasing demand for new loans.

Greater wealth, as well as lower import prices, will stimulate Greater wealth, as well as lower import prices, will stimulate aggregate demand and improve economic fundamentals. aggregate demand and improve economic fundamentals.

These two wealth effects are mutually reinforcing, These two wealth effects are mutually reinforcing, increasing demand for domestic assets, including increasing demand for domestic assets, including domestic currency, leading to a further currency domestic currency, leading to a further currency appreciationappreciation

The feed back effects of The feed back effects of exchange rate appreciationexchange rate appreciation

Moreover,…Moreover,… Foreign loans are usually taken in order to invest or Foreign loans are usually taken in order to invest or

purchase some assets.purchase some assets. Therefore, the acceleration of foreign re-lending Therefore, the acceleration of foreign re-lending

usually corresponds to higher asset prices which will usually corresponds to higher asset prices which will increase banks´ profits as well as the income of their increase banks´ profits as well as the income of their clients. clients.

In many currency dependent economies, large In many currency dependent economies, large increase in bank equity have preceded banking crisis. increase in bank equity have preceded banking crisis.

Foreign currency lending can create a virtuous cycle Foreign currency lending can create a virtuous cycle of demand for domestic currency and domestic of demand for domestic currency and domestic assets, and appreciation of the exchange rate. assets, and appreciation of the exchange rate.

The feed back effects of The feed back effects of exchange rate appreciationexchange rate appreciation

Up by the escalatorUp by the escalator

Similarly, a depreciation will have a negative wealth effect, but Similarly, a depreciation will have a negative wealth effect, but at a much faster rate, a phenomena described by the “up by the at a much faster rate, a phenomena described by the “up by the stairs, down by the elevator” principle. stairs, down by the elevator” principle.

The currency appreciation and wealth creation is usually The currency appreciation and wealth creation is usually gradual, and the depreciation and wealth destruction fast and gradual, and the depreciation and wealth destruction fast and violent.violent.

As the net asset position is increased, and the economy heats As the net asset position is increased, and the economy heats up, an increasing number of informed agents build up an up, an increasing number of informed agents build up an expectation of a currency depreciation. expectation of a currency depreciation.

Nobody wants to be the last to hedge their currency positions, Nobody wants to be the last to hedge their currency positions, and a large number of agents may attempt to reverse their and a large number of agents may attempt to reverse their positions simultaneously. positions simultaneously.

As the result, the exchange rate fall very drastically as the as As the result, the exchange rate fall very drastically as the as domestic agents try to hedge their currency risk by aquiring domestic agents try to hedge their currency risk by aquiring foreign assets and/or selling domestic assets. foreign assets and/or selling domestic assets.

Down by the Elevator Down by the Elevator

The boom is gradual, the crash is rapid and The boom is gradual, the crash is rapid and violent.violent.

Rapid exchange rate depreciation causes the Rapid exchange rate depreciation causes the value of debts and assets to move in opposite value of debts and assets to move in opposite directions, leading to wealth destruction and directions, leading to wealth destruction and credit crunch.credit crunch.

See e.g. Kaminsky & Reinhart (2000) on the See e.g. Kaminsky & Reinhart (2000) on the stylized facts of the twin crisis, how a collapse stylized facts of the twin crisis, how a collapse in the exchange rate leads a banking crisis in in the exchange rate leads a banking crisis in 6-12 months.6-12 months.

Monetary policy in currency Monetary policy in currency dependent economiesdependent economies

Weak interest rate pass-throughWeak interest rate pass-through An inflation targeting central bank can be successful in the short–An inflation targeting central bank can be successful in the short–

term, while at the same time its contractionary policy interventions term, while at the same time its contractionary policy interventions may not only pass–by but actively encourage growing imbalances may not only pass–by but actively encourage growing imbalances in the financial sector. in the financial sector.

Borio and White (2004), maintain that episodes of financial Borio and White (2004), maintain that episodes of financial instability with serious macroeconomic costs have been more instability with serious macroeconomic costs have been more frequent in recent times of price stability, than when inflation was frequent in recent times of price stability, than when inflation was more prevalent, both in developed and emerging markets. more prevalent, both in developed and emerging markets.

This suggests that financial and price stability objectives may be in This suggests that financial and price stability objectives may be in conflict with each other, the so-called“paradox of credibility”. Borio conflict with each other, the so-called“paradox of credibility”. Borio and Lowe (2002), Borio and White (2004) and Goodfriend (2003). and Lowe (2002), Borio and White (2004) and Goodfriend (2003).

Monetary policy in CDEs is especially challenging because of the Monetary policy in CDEs is especially challenging because of the importance of the exchange rate. importance of the exchange rate.

The duality of the exchange rate with the respect to monetary The duality of the exchange rate with the respect to monetary policy and financial regulation may be the cause of a conflict policy and financial regulation may be the cause of a conflict between price and financial stability. between price and financial stability.

(In)effectiveness of Monetary (In)effectiveness of Monetary policypolicy

For currency dependent economies in a boom, interest rate For currency dependent economies in a boom, interest rate increases may have the perverse effect of stimulating the increases may have the perverse effect of stimulating the economy in the short-run.economy in the short-run.

Higher interest rates increase spread between foreign and Higher interest rates increase spread between foreign and domestic loans, increases the attractiveness of foreign domestic loans, increases the attractiveness of foreign lending, lending,

The resulting exchange rate appreciation creates positive The resulting exchange rate appreciation creates positive wealth effects which may stimulate aggregate demand as wealth effects which may stimulate aggregate demand as well as asset markets.well as asset markets.

At least, contractionary monetary policy, might do little to At least, contractionary monetary policy, might do little to constrain banks that are experiencing rapid improvements of constrain banks that are experiencing rapid improvements of their equity position and lower capital charges.their equity position and lower capital charges.

(In)effectiveness of Monetary (In)effectiveness of Monetary policypolicy

Similarly, an expansionary policy in times of crisis is Similarly, an expansionary policy in times of crisis is likely to backfire with a further depreciation of the likely to backfire with a further depreciation of the exchange rate and wealth destruction. exchange rate and wealth destruction.

In fact, policy responses to currency and bank crisis in In fact, policy responses to currency and bank crisis in currency dependent economies have invariably been currency dependent economies have invariably been procyclical. E.g. in the Asian crisis, Chile, etc.procyclical. E.g. in the Asian crisis, Chile, etc.

Authorities are forced to respond to negative shocks Authorities are forced to respond to negative shocks with a monetary contraction and higher interest rates to with a monetary contraction and higher interest rates to shore up the exchange rate against a massive outflow shore up the exchange rate against a massive outflow of foreign currency.of foreign currency.

They even have to inject new bank capital into the They even have to inject new bank capital into the system or take over failed banks in order to prevent a system or take over failed banks in order to prevent a collapse of the financial system. collapse of the financial system.

ProposalsProposals

Summary of ProblemSummary of Problem

If foreign exchange risk is not properly If foreign exchange risk is not properly incorporated in banks’ regulatory capital, incorporated in banks’ regulatory capital, the banks have incentives to lend the banks have incentives to lend excessively in booms, and contract excessively in booms, and contract excessively in crisis excessively in crisis

One reason is wealth effectsOne reason is wealth effects banksbanks and their borrowersand their borrowers and even 3and even 3rdrd parties parties

What to do?What to do?

1.1. measure currency risk correctly: probably measure currency risk correctly: probably impossibleimpossible

2.2. or expose banks to currency risk by other or expose banks to currency risk by other meansmeans

We can either:

ProposalProposal

Capital charges arising from foreign Capital charges arising from foreign currency lending could be in the same currency lending could be in the same currency, so e.g.currency, so e.g.

A bank in Poland making a Euro loan of A bank in Poland making a Euro loan of €100, would carry its capital charge from €100, would carry its capital charge from that loan in Euros, i.e. 8% risk weighted of that loan in Euros, i.e. 8% risk weighted of the €100 the €100

ImplicationsImplications

1.1. Capital charges are relatively Capital charges are relatively countercyclical,countercyclical,

because the internalization of currency risk into the capital margin because the internalization of currency risk into the capital margin of banks, reduces the capital ratio and increases the capital cost of banks, reduces the capital ratio and increases the capital cost of foreign currency lending in times of booming asset markets, and of foreign currency lending in times of booming asset markets, and lessens the severity of loan contraction during crisislessens the severity of loan contraction during crisis

1.1. Monetary policy is more effective,Monetary policy is more effective, since interest rate changes have a direct relationship since interest rate changes have a direct relationship

with the level of banking activity, via the impact on with the level of banking activity, via the impact on bank capital due to exchange rate changesbank capital due to exchange rate changes

1.1. Lower currency reserves needed by the CB,Lower currency reserves needed by the CB, since the central bank can keep lower levels of currency reserves, since the central bank can keep lower levels of currency reserves,

because it does not need to sterilize inflows due to foreign because it does not need to sterilize inflows due to foreign currency lending, nor maintain as high a cushion for times of crisiscurrency lending, nor maintain as high a cushion for times of crisis

The ratio of currency linked loans out total The ratio of currency linked loans out total loan portfolio in the Icelandic banking systemloan portfolio in the Icelandic banking system

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