Countercyclical Capital Charges and Currency Dependent Economies

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Countercyclical Capital Charges and Currency
Dependent Economies

• Jon Danielsson
• Asgeir Jonsson
• April 2005

London School of Economics www.RiskResearch.org
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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

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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

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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

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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

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Basel-II, IRB Banks, and Currency Dependence

• IRBInternal 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 banks foreign currency assets and
  liabilities match in amounts and maturities
• Is the bank currency hedged? NO
• Ignores foreign exchange risk affecting credit
  risk

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Measurement of Market Risk in Basel-I and II

• ValueatRisk (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?

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Mexican Peso/USD Returns
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(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

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Or

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

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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

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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

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What to do?
We can either

• measure currency risk correctly probably
  impossible
• or expose banks to currency risk by other means

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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

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Implications

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