Reforming Bank Capital Requirements: Implications of Basel II for Latin American Countries

The appropriate regulation of banks is a hotly contested topic in both industrialized and developing countries. This year the Basel Committee on Banking Supervision put forward a controversial proposal to overhaul the 1988 Basel Accord that has long guided the regulation of bank capital across over a hundred countries.¹ The thirteen member countries of the Basel Committee on Banking Supervision are due to apply Basel II, as the new accord is called, by 2007. If and how other countries should apply Basel II—and therefore whether the new Accord will be successful as a standard—remains an open question. If Basel II is applied across the globe, then its details will be extremely relevant; if not, it will be important to understand why many emerging countries decided to retain Basel I despite its well-known drawbacks.²

It is widely accepted that bank capital should be regulated, but how to do so remains open to debate.³ The simple approach of Basel I divides assets into very broad risk categories and establishes an 8 percent minimum capital requirement for risky assets.⁴ However, as bank risk management has become more sophisticated and as the possibilities for transforming asset risk have grown, the potential distortions created by these simple rules and the opportunities for arbitraging across them have multiplied.⁵ By contrast, Basel II goes well beyond simply recasting quantitative requirements. Making capital requirements more risk sensitive and reducing regulatory arbitrage are main objectives of the new accord.⁶ Basel II proposes two basic approaches: the standardized approach, which uses external credit rating agencies together with a table that maps those ratings directly into capital requirements; and the internal ratings-based (IRB) approach, in which the banks themselves estimate their customers' default probability—without relying on external rating agencies—and then use a particular formula specified in Basel II to determine capital requirements as a function of the default probability and other parameters.⁷

This paper focuses on one specific but critical issue and on a set of more general questions. We analyze whether the IRB approach as calibrated is appropriate for the Latin American context. We believe that this is the first paper to estimate credit risk across a set of emerging economies using a simple and homogeneous methodology. We find significant differences between our estimates from the region and those from the Group of Ten (G10) countries. These differences have strong implications for the application of the IRB approach.

We also discuss Basel II implementation for Latin America and more generally across all emerging countries. Typically there are few external rating agencies in these countries, so the standardized approach would have little effect in linking regulatory capital to risk.⁸ But the IRB approach may not be calibrated appropriately for emerging markets, and its implementation and supervision may stretch limited supervisory resources. Given the data on compliance with the Basel Core Principles for Effective Banking Supervision across Latin America, it may not be advisable for many countries to implement the IRB approach for a long time.

Given this situation, we suggest an innovative simplification of the IRB approach that builds on current policies regarding provisioning in some emerging countries and that may be used as a transition arrangement toward the IRB approach. We call this the centralized ratings-based (CRB) approach. Under this approach, banks would rate their clients, but the regulator would determine the rating scale and the way in which the banks' ratings map into default probabilities. The use of a centralized scale would facilitate comparison across banks and greatly ease the monitoring of banks' ratings.⁹ Those requirements would also be easier to monitor, since the regulator would determine how banks' ratings would feed into capital requirements.

Countries must choose whether to stay on Basel I or, if not, which Basel II alternative to apply (here we include...