Evaluation of the Bankâ€™s Capital Adequacy and Loan Charges Policy Office of Evaluation and Oversight (OVE)
Inter-American Development Bank Washington D.C. October 2006
For Official Use Only
PROJECT SUMMARY I.
INTRODUCTION ................................................................................................................. 1
BACKGROUND................................................................................................................... 2 A. B. C.
EVALUATION OF THE MODEL ........................................................................................... 7 A. B. C. D. E. F. G.
Description of the previous policy: 1990-2002 .................................................. 18 Description of the current policy: 2003-present ................................................. 19 Analysis of the current policy.............................................................................. 21 Results of the evaluation...................................................................................... 27
FINANCIAL AND OPERATIONAL IMPACTS....................................................................... 28 A. B.
Description of the model........................................................................................ 8 General assumptions .............................................................................................. 9 Specific assumptions............................................................................................ 11 Attainment of objectives...................................................................................... 14 Benchmark model ................................................................................................ 15 Simulations........................................................................................................... 17 Results of the evaluation...................................................................................... 18
EVALUATION OF THE POLICY ......................................................................................... 18 A. B. C. D.
Chronology of the loan charge policy................................................................... 2 Chronology of the capital adequacy policy .......................................................... 5 Conclusions ............................................................................................................ 6
Financial impact ................................................................................................... 28 Operational impact............................................................................................... 29
CONCLUSIONS AND RECOMMENDATIONS ...................................................................... 29 A. B.
Conclusions .......................................................................................................... 29 Recommendations................................................................................................ 30
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EMBI+ FSO GAAP IBRD ICR IDB IMF MDB NLF OLB OVE RLR SLL TELR VaR
Emerging markets bond index plus Fund for Special Operations Generally accepted accounting principles International Bank for Reconstruction and Development Interest coverage ratio Inter-American Development Bank International Monetary Fund Multilateral development bank New lending framework Outstanding loan balance Office of Evaluation and Oversight Reserves-to-loans ratio Sustainable level of lending Total-equity-to-loans ratio Value-at-risk
In October 2003, the Budget and Financial Policies Committee (BUFIPOL) proposed that the Board of Directors approve a new capital adequacy policy and methodology for the calculation of loan charges for ordinary capital loans and guarantees. The Committee agreed that: “OVE should conduct an evaluation of the performance of the new capital adequacy model and policy two years after its approval, assessing how well it has fulfilled its objectives, and reporting on its financial and operational effects.
This document fulfills that requirement by evaluating the performance of both the model and the policy, as well as reporting its main financial and operational effects. The findings of the evaluation are tentative and preliminary because both the model and the policy were only very recently implemented. For instance, the region’s full economic cycle cannot be included in the analysis.
Historically, the loan charge policy and the capital adequacy policy—while clearly related—have been managed independently. The policy under evaluation consolidated both policies. This was accomplished by establishing a loan charge policy that guarantees stable loan charges, as long as the total equity to loans ratio (TELR) remains within a specified band, projected net income is positive, and the projected TELR is rising. Outside of the established band, or when the other conditions are not met, the policy is discretionary.
The objectives of the current capital adequacy and loan charge policy are four-fold: (i) provide stable lending rates (ii) even in times of need for the Region (iii) using a risk-based framework (iv) that is simple and transparent. In order to achieve these objectives, a credit risk model was developed to measure the risk exposure of the Bank’s loan portfolio in various crisis scenarios. It is precisely this measurement of risk exposure that directly determines the band for the TELR in which standard (constant) loan charges are recommended. The model represents Management’s best estimate of potential losses in extreme scenarios associated with the Bank’s credit risk.
The objective of providing stable lending rates is directly related to the conditions in the supranational and sovereign debt markets. The ability to lend regardless of the conditions prevailing in the Region is inherently linked to the capital adequacy policy. The aim of the loan charge policy is to define a spread over the Bank’s financial costs that makes the business sustainable and beneficial to all stakeholders, while the aim of the capital adequacy policy is to define the Bank’s risk-bearing capacity.
II. BACKGROUND 2.1
This section presents a chronology of the loan charge policy and of the capital adequacy policy, in order to place them in the Bank’s historical context. In addition, some conclusions on the evolution of this process are offered.
Chronology of the loan charge policy 1.
The effective interest rate on the Bank’s loans to national governments is determined on the basis of the cost of funding plus a reasonable charge spread. The rate is set semiannually, which means that every six months the Bank’s borrowing cost is calculated, in order to apply to it the loan charges.
Loan charges consist of three basic charges: (i) an annually lending spread of 50 basis points applied to the outstanding loan balance (OLB), (ii) a commitment fee of 75 basis points on undisbursed loans, and (iii) a one-time inspection and supervision fee of 100 basis points allocated over 4 years.
A waiver on these charges may be granted when the Bank’s financial position allows it. The first of these three charges that may be reduced, to zero if possible, is the inspection and supervision fee. If there is room for lowering the loan charge still further, then the commitment fee may be reduced. And, if a further reduction is still possible, then the lending spread is lowered as much as possible. However, if an unfavorable financial position requires the Bank to increase its charges, only the lending spread may be raised. The other two charges may be decreased, but not increased.
The equivalent lending spread is a measure that consolidates the three charges into a single one. This charge is defined as the pricing level that would generate a net present value of income equal to the net present value of income produced by the three charges described. 2.
Prior to 1975, the loan charges policy was to maintain stable charges for as long as possible. The loan charges were not set on the basis of any precise formula, but rather were evaluated from time to time for general consistency with the Bank’s financial and developmental objectives (financial soundness and ability to set low and stable loan rates).1 Accordingly, the loan charges were set “at approval” of the loans. 3.
In 1976, when the interregional capital was created and new nonregional countries were admitted as members, the Bank adopted a new loan charge policy known as
Document FN-121, page 4, second paragraph.
“full cost coverage”, whereby a single cost base was adopted to determine the loan charges that would apply to ordinary capital and interregional capital resources. This consisted of “normalizing” borrowing costs on a 12-month basis, and adding a spread of 48 basis points to cover administrative costs and the cost of holding liquidity.2 The change was made to ensure sufficient growth in reserves to offset possible unexpected losses, following the trend of other multilateral development banks (MDBs) such as the International Bank for Reconstruction and Development (IBRD). 2.8
Under the new policy, member countries assumed the Bank’s total market cost of guaranteeing long-term financing with fixed loan charges. In exchange, they received the benefit of maintaining the Bank’s creditworthiness and access to an acyclical line of credit with fixed loan charges. Since the loan charges were fixed “at approval”, however, and the liquidity policy implied “partial coverage” 3, rising interest rates led to a substantial reduction in the lending spread, which even reached negative levels in the early 1980s.5 The loan charge policy did not allow “full cost coverage” because between the time a loan was approved and the time the first disbursement was made, the borrowing costs would increase due to higher interest rates, and the Bank would ultimately incur a loss. 4.
To solve this problem, in 1983 it was decided that loan charges would be “fixed-atdisbursement” (when borrowing costs were known), based on the Bank’s average cost of funding in the preceding 12 months, plus a spread of 50 basis points to cover administrative and other costs.6 This change in the pricing policy resulted in “full cost coverage” and addressed the interest rate risk. Interest rate risk was not eliminated, however, but transformed into credit risk because the change translated uncertainty about the level of loan charges at the time of disbursement into uncertainty of its level at the time of approval. In a context of high volatility of interest rates, charges set ex post could be much higher than those assumed by the borrowing country ex ante, thus increasing the likelihood of default (i.e. credit risk).
The 1980s was a decade of economic and financial turbulence in the Region. By around 1984, gross domestic product in Latin America had declined by 30% from 1980. Between 1982 and 1988, capital flight from the Region amounted to
Document FN-85-1, page 4, second paragraph.
The partial coverage policy was designed to gradually scale back liquid asset coverage of undisbursed loan commitments (which, at the time, was 100%) by reducing pre-borrowing to the maximum between 50% of undisbursed loan commitments and the amount corresponding to two years of projected disbursements.
The partial coverage policy was designed to gradually scale back liquid asset coverage of undisbursed loan commitments (which, at the time, was 100%) by reducing pre-borrowing to the maximum between 50% of undisbursed loan commitments and the amount corresponding to two years of projected disbursements.
Document GP-120-2, Annex II-A, page 8, paragraph 18.
Document FN-173-2, page 1, paragraph 2.
US$180 billion, equivalent to 29% of the Region’s production. At the same time, interest rates were still steadily rising, and there was a high credit risk due to the “fixed-at-disbursement” feature of the loan charge policy, as discussed in the preceding paragraph. 2.11
In this context, the Bank’s loan portfolio deteriorated, with borrowers in nonaccrual status accounting for 8% of the outstanding loan balance (OLB). Furthermore, the largest borrower remained in nonaccrual status for six consecutive months. This was the Bank’s first experience with cases of arrears and borrowers in nonaccrual status. This situation presented new developmental challenges on how to generate rapidly and equitably the income required in order to ensure the Bank’s financial soundness.7
The policies at that time did not give the Bank sufficient flexibility to reconcile the conditions of the financial markets with the needs of its borrowing member countries. This inflexibility was produced by the supply of long-term loans with fixed loan charges, which limited the Bank’s options for minimizing its borrowing costs and the base cost for fixed loan charges.8 In this context, the Bank needed to develop a mechanism that would provide enough flexibility to take into account both current and projected market conditions when pursuing its objectives. 5. 1990-2002
In 1990, the Bank made several changes to its loan charge policy in order to obtain consistent returns and reduce its borrowing costs. First, the Bank set a net income target, whereby (i) a net income target level was determined (defined as the minimum level of income required to maintain the Bank’s credit standing in financial markets) based on return and reserve ratios, and (ii) it was agreed to assess every six months the adequacy of loan charges with respect to the net income target and to recommend any necessary adjustments.9 The net income target “would allow the Bank for the first time in its history to generate additional loan proceeds during times of crisis and to waive loan charges when a sound financial position permitted”. 10
The variable lending rate system was also adopted to replace both the fixed loan charges and the strategy of determining loan charges in tranches at the time of disbursement. The main features of this change were: (i) to apply the prevailing loan charges to all outstanding balances, irrespective of date of loan approval or date of disbursement, (ii) to use a pool-based average rather than a marginal cost of funding as the basis for setting the loan charges, (iii) to adopt a variable lending spread, and (iv) to review semiannually the loan charges that borrowers must pay
Document GP-120-2, Annex II-A, page 10, paragraph 38.
Document GP-120-2, Annex II-A, page 11, paragraph 39.
Document FN-415, page 26, paragraph 3.2.
Document GP-120-2, Annex II-A, page 11, paragraph 40.
on any given loan.11 A system of variable charges had important advantages over the previous system: (i) flexibility in the response to changes in the Bank’s financial position, (ii) equality among borrowers, (iii) funding flexibility, (iv) protection against interest rate risk, and (v) reduced variability and uncertainty over the borrowing cost base for purposes of calculating the Bank’s loan charges.12 2.15
The new policy for setting loan charges worked well for most of the 1990s. However, the emergency lending program, created in 1998 in response to an economic crisis in the Region, changed the characteristics of the Bank’s lending instruments. In particular, it increased the speed of disbursements and created a permanent emergency lending window.13 In this context, the net income target was exceeded in successive years between 1999 and 2001 because in order to meet the net income target loan charges inconsistent with the capital adequacy policy needed to be set (see following subsection) and it was considered more important to comply with the capital adequacy policy. Further, the Net Income Policy implied maximum waivers in a context of financial crisis for the countries of the Region. This particular inconsistency was due to the fact that the policy was concentrated on information internal to the Bank. 6. 2003-present
The inconsistency between the policies led the Board to approve in 2003 a “new capital adequacy policy and methodology for calculating loan charges on ordinary capital loans and guarantees”. This new policy, which will be analyzed in detail in latter sections of this document, eliminates completely the net income target.
Chronology of the capital adequacy policy 1. Previous concepts
In commercial banking, bank risk is typically defined as the volatility of return. This volatility implies potential losses, which imposes the need for capital to cover their potential occurrence. The situation is similar for the Inter-American Development Bank (IDB), except that as a self-regulated institution valued for its ability to act in times of crisis, capital requirements are substantially greater.
The Bank’s subscribed capital is composed of paid-in and callable capital. Paid-in capital has been contributed in United States dollars or in convertible currencies of the member countries. The callable portion of capital may only be called in exceptional cases to meet the Bank’s obligations. 2.
From its inception until 1990, an explicit capital adequacy policy was not considered necessary to manage the Bank’s risk. For example, the view in 1978
Document FN-415, page 7, paragraph 2.12.
Document FN-415, page 8, paragraph 2.16.
Document FN-568, page 3, paragraph 11.
was that holding a General Reserve “which can be viewed as bearing an adequate relationship to the Bank’s exposure in its loan portfolio” was seen as sufficient:14 2.20
Since it was founded, the Bank has a lending authority limit that was closely linked to the level of capital. Specifically, according to the Agreement Establishing the Bank, the Bank’s loans and guarantees may never exceed the sum of the unimpaired callable capital, paid-in capital, and the general reserve. Likewise, the net borrowing policy (for liquidity funding) establishes that this amount should be less than the sum of callable capital and special reserves. 3. 1991-2002
After experiencing for the first time cases of arrears and borrowers in nonaccrual status (see paragraph 2.12), the Bank introduced its first capital adequacy policy, which required a reserves-to-loans ratio (RLR) to lie within a band of 20% to 25%. The goal was to ensure an acceptable range of reserves that would enable the Bank to absorb unexpected losses in periods of potential crisis.
The capital adequacy policy worked well for most of the 1990s owing to several factors. First, the Region’s risk level was at least acceptable. Second, the Bank offered only two lending instruments with similar disbursement and repayment characteristics. Hence, exposure and concentration levels by country were predictable and resulted in fairly stable income levels, sufficient to meet the policy’s capital adequacy target (i.e. 20%<RLR<25%).15
In 1998, financial projections indicated that the Bank’s RLR would pierce the upper boundary of the band (25%) by 2004-2005, as a result of the introduction of the emergency lending program. In addition, between 1999 and 2001, the capital adequacy policy was inconsistent with the loan charge setting policy (see paragraph 2.15). 4. 2003-present
In 2003 when it became evident the capital adequacy policy would be unsustainable after 2004 and was inconsistent with the loan charges policy, the Board approved the “new capital adequacy policy and loan charge methodology for ordinary capital loans and guarantees”.
Based on the above chronologies, some conclusions can be reached regarding the historical trends in the policies that are the object of evaluation in this document.
First, since its inception, the Bank has been flexible in modifying its policies in order to align its mandate with the changing needs of the countries in the Region. Thus, the Bank has had a loan charge policy since the 1960s, which has been subject to numerous revisions until the net income target was proposed in 1989.
Document FN-144, page 4.
Document FN-568, page 4, paragraph 20.
According to Management, the net income target “would allow the Bank for the first time in its history to generate additional loan proceeds during times of crisis and to waive loan charges when permitted by a solid financial position”. 16 2.27
Second, the capital adequacy policy, as a complement to statutory limits, emerged in response to arrears and borrowers in nonaccrual status that occurred for the first time towards the end of the 1980s. Significantly, the need for a explicit capital adequacy policy emerged independently of the loan charge policy (although both were always managed together).
Third, the inconsistency in the late 1990s between the loan charge policy and the capital adequacy policy led to a proposal for integrating the Bank’s loan charge policy and its capital adequacy policy for the first time. Specifically, the focus of the current loan charge policy shifted completely from the net income target to a capital adequacy measure.
Finally, as it evolved, the loan charge policy never considered necessary to explicitly incorporate market factors associated with the relative price of financing for the countries. New financing trends in the countries of the Region show that the pattern of competition in sovereign debt markets has changed substantially. In addition to MDBs, alternative sources of financing currently include (i) international commercial banks operating locally, (ii) private pension funds, (iii) capital markets, and (iv) international reserves as a self-insurance mechanism to protect against international illiquidity. III. EVALUATION OF THE MODEL
Selecting a credit risk model is no simple task. In this regard, the Basel Committee on Banking Supervision (1999) notes that:17 “The choices of conceptual methodology that a bank makes when building a credit risk model are largely subjective ones, based on considerations such as the characteristics of the bank’s loan portfolio and its credit culture. (...) As such, the Committee welcomes further dialogue with the industry in order to assess the impact of these choices on a model’s accuracy and performance.”
This subjectivity is even greater in the case of the IDB, given its special characteristics with respect to commercial banking. In particular, its situation as a self-regulated institution, its preferred creditor status, and its high level of portfolio concentration mean that more assumptions have to be considered.
The strategy for the evaluation of the model concentrates on the methodological choices, analyzing the structure and compatibility of the assumptions with the
Document GP-120-2, Annex II-A, page 11, paragraph 40.
Basel Committee on Banking Supervision (1999) "Credit Risk Modeling: Current Practices and Applications”, page 18.
Bank’s risk profile. Fulfillment of the model’s objective to react to changes in portfolio quality was subsequently assessed. 3.4
The model is designed to calculate the required capital that is consistent with the credit risk assumed by the Bank. Inputs into the model are: borrower’s exposure, borrower information, and the model’s parameters. The borrower’s exposure includes: type of loan or guarantee, grace period, disbursement profile, contractual interest rate, and exposure (OLB) with the Bank. Borrower information includes: risk rating, severity of default, and the preferred creditor status adjustment. Lastly, the model’s parameters include: the matrix of correlations between default probabilities, the horizon (in semiannual periods), and the average borrowing rate for each six-month period. The output of the model is a loss distribution that allows the calculation of economic capital. The required total-equity-to-loans ratio (TELR) is subsequently determined as the ratio of economic capital to loans and guarantees.
Description of the model
The structure of the model is based on three key components: probability of default (P), severity of default (S), and exposure to default (E), which when multiplied give the expected loss (L).18 The structure described reflects the internal ratings-based method proposed by Basel II for internationally active banks. In general, it is an effective structure for capturing the Bank’s credit risk.
The Bank’s credit risk can be broken down into three categories: (i) idiosyncratic risk, or the risk that a given country will default for reasons specific to that country, (ii) covariance risk, or the risk that a group of countries will default as a result of a common disruption, and (iii) concentration risk, which occurs when a limited number of borrowers comprise a significant proportion of the portfolio. Concentration risk increases the financial impact of idiosyncratic and covariance risks. In the Bank’s model, idiosyncratic risk is captured by external risk ratings and the preferred creditor status adjustment. Covariance risk is captured by correlations of the region’s securities markets. Lastly, concentration risk is incorporated into the model through an adjustment to the exogenous and constant parameter of average severity.
The model employs two types of assumptions. General assumptions are associated with global aspects related to the model’s three key elements. They reflect the basic methodological options and seek to capture the nature and characteristics of the risks managed by the Bank, optimizing available information and resources. In that regard, they represent the initial design decisions, providing support or scaffold, for the measurement of potential losses. Modifications at this level imply significant changes in the methodological approximation. In contrast, specific assumptions are tied to each key element of the model. To summarize, figure 3.1 presents the model’s structure and the main general and specific assumptions. It is followed by a
Expected loss = P x E x S
brief description of each assumption, along with a discussion of its relevance, given the Bank’s risk profile. Figure 3.1 Type of default
Exposure to default Current and future portfolio
Monte Carlo simulation
Probability of default
Severity of default
Derived from risk ratings
Fixed average severity
Preferred creditor adjustment
Securities market correlations
General assumptions 1.
Type of default
The definition of risk implies a conceptual definition of default. Default can take one of two forms: default mode (binary) or mark-to-market (gradual migration). In the default mode, a loss occurs only if the borrower defaults on its obligation within the relevant horizon. This binary characteristic makes the model sensitive to the selected horizon. In contrast, in the mark-to-market mode, a loss can result from a decrease in the quality of the loan without an event of default, but rather due to the different discount rates applicable to each level of risk. In this case, in addition to the probability of default, the probability of migrating towards intermediate risk ratings between default and non-default must be estimated. This involves the estimation of transition matrices for risk ratings. This approach is theoretically more accurate than the default mode, but at the same time is more costly and requires a broad database on the ratings of borrowers that allows the transition matrix to be estimated. The Bank’s model assumes a default mode that is clearly less costly, better suited to the information currently available, and also somewhat less precise than the alternative paradigm.19 For these reasons, while a mark-tomarket loan rating system could be introduced, the default mode adopted by the Bank is acceptable. 2. Unconditional model
A crucial element in risk assessment is the distinction between unconditional and conditional default probabilities. The Bank’s model considers unconditional default probabilities—default simply happens; it is not driven by variables analyzed by the
Although the model has a module designed to enter the transition matrix required in the mark-to-market paradigm, that module has not been used up to this time.
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model. However, it is feasible to identify and predict risk factors by using macroeconomic and financial variables. Estimating the conditional probabilities of default would provide more valuable and accurate information regarding expected losses. Although modeling the economic cycle is generally a complicated process, given the sovereign nature of the borrowers, it would be recommendable to explore the possibility of migrating to a conditional model. Ideally, such migration would involve a joint effort by the Bank’s Research and Finance Departments.20 The benefits of such an exercise would include better integration of the research work of the Bank with the operational exercise of establishing the Bank’s risk exposure. 3. Bottom-up aggregation 3.10
There are two approaches for aggregating credit risk: bottom-up or top-down. The bottom-up method calculates credit risk at the loan level based on an explicit evaluation of the borrower’s solvency. The information is subsequently aggregated at the portfolio level taking into account the effects of diversification. The top-down approach places loans with similar risk profiles into different groups. Credit risk is calculated at the group level, and in each group the loans are treated as statistically identical. Accordingly, the estimate is made by group rather than by loan. If the main credit risk factor is the risk that a given country will accrue arrears in all of its obligations with the Bank, the best aggregation method would be at the country level. However, if the main credit risk factor is diversification by type of loan in each country, the best aggregation method would be at the loan level, as currently assumed in the Bank’s credit risk model. This characteristic is important to the extent that the model is designed to easily incorporate changes in the composition of the Bank’s portfolio with greater participation from the private sector or subnationals without sovereign guarantees. 4. Monte Carlo simulation
In market risk models, it is common to assume a normal distribution as a benchmark. An adequate estimate of the mean and variance then fully define the distribution. In contrast, in the case of credit risk it is known that: (i) extreme losses occur with greater frequency than extreme gains, and (ii) the occurrence of extreme values in general is greater than in the normal distribution. Consequently, the normal distribution does not accurately represent losses arising from credit risk. In this context, different approaches can be adopted for purposes of estimating the loss distribution: numerical methods, econometric analysis, historical simulation, or the Monte Carlo simulation, among others. The Monte Carlo simulation provides accurate results even when the availability of historical data is fairly limited. This is because an empirical distribution is built on the basis of available data. Given the lack of a sufficiently broad database on the Bank’s portfolio risks, the Monte Carlo simulation method adopted is considered appropriate for the Bank.
“In a broad sense, all models are conditional” Gallati, Reto “Risk Management and Capital Adequacy” 2003. p 148. The Bank’s model, for example, is conditional on the S&P’s risk ratings and on the internal risk ratings generated by the Credit Risk Office (EVP/CRA) for the Bank’s exposure with the private sector.
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Specific assumptions 1.
Exposure to default a. Current and future portfolio
There are two components to the Bank’s credit exposure: (i) levels of exposure associated with the current portfolio, and, potentially, (ii) levels of exposure associated with future loans. This dynamic and multiperiod nature of the model allows possible changes in borrower risk to be incorporated at the time the level of required reserves and capital are determined for the Bank, as prescribed by best industry practices. Even though the model has a module designed to incorporate the two components, however, only the former is currently used. 2.
Probability of default a.
Based on external risk ratings
In general, default probabilities can be obtained from various sources: (i) internal data taken from the Bank’s historical record, (ii) intuitive factors determined by experienced loan officers, (iii) external risk ratings, or (iv) variables associated with borrower risk. Given that (a) the IDB does not have a sufficiently broad internal database in order to estimate default probabilities, and (b) the model requires numerical data that are not derived from the subjective opinions of loan officers, the remaining alternatives are to determine default probabilities based on external risk ratings or variables associated with borrower risk.
The Bank’s capital adequacy model calibrates the default probabilities of each loan based on the external information provided by Standard & Poor’s risk ratings. This option has the advantage of being transparent and easily applied. However, there is broad consensus on the inability of those indicators to anticipate changes in default probabilities. In this regard, Reinhart (2002) asserts that:21 “As to the ability of rating changes to anticipate financial crises, the empirical tests presented here on sovereign credit ratings and financial crises suggest that sovereign credit ratings systematically fail to anticipate banking and currency crises. This result appears to be robust across alternative crises definitions, model specification, and approaches. (...) As regards the behavior of ratings after the crisis and differences between developed and emerging markets, there is evidence that sovereign credit ratings tend to be reactive—particularly when it comes to EMs.”
Likewise, Saunders and Altman (2002) present the following argument in reference to commercial operations:22
Reinhart (2002) “Sovereign credit ratings before and after financial crises” in Ratings, Rating Agencies and the Global Financial System. Kluwer Academic Publishers.
Altman and Saunders (2002) “The role of credit ratings in bank capital” in Ratings, Rating Agencies and the Global Financial System. Kluwer Academic Publishers.
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“Relying on ‘traditional’ agency ratings could produce cyclically lagging rather than leading capital requirements, resulting in an enhanced rather than reduced degree of instability in the banking and financial system. (...) the appropriate weighting system that bank regulators sanction will be based on a combination of external and internal ratings, or only on the latter.” 3.16
Hence, the possibility of migrating to a different system for obtaining default probabilities should be explored. For example, it would be feasible to infer the probabilities based on the risk premiums of the debt of borrowing member countries. These premiums reflect the probability of default of this class of debt according to the market perceptions. Alternatively, the Bank could follow the recommendation of the Basel Committee on Banking Supervision (Basel II) for measuring sovereign risk, and use the consensual risk ratings of the Export Credit Agencies of developed countries. 23 b.
Preferred creditor status adjustment
As mentioned earlier, the Bank’s model determines default probabilities on the basis of the external Standard & Poor’s risk ratings. Those probabilities are associated with events of borrower default on commercial debt, and, therefore, must be adjusted to reflect the Bank’s preferred creditor status. That adjustment corresponds to a reduction in the probability of default due to the support the Bank receives from member countries. This is a special characteristic recognized by the market and risk rating agencies that evaluate the Bank, and has been evident on numerous occasions.
The Bank’s model proposes a preferred creditor status adjustment specific to each country that is inversely related to (i) multilateral debt as a percentage of country debt, and (ii) the country’s historical arrears ratio with the Bank. As both variables reflect the degree of borrower risk, the preferred creditor adjustment is always inversely related to borrower risk level.
In this model, the correction is a variable that follows an inverse relation with the correction requested in document FN-568-1.24 This is the result of two different lines of reasoning on the relationship between the borrower’s level of risk and the preferred creditor status adjustment. Under the model’s current assumption, a country with a greater degree of risk should receive a smaller preferred creditor status adjustment, so that the country’s risk condition is not underscored. In contrast, in document FN-568-1, the request referred to the high value that the risky borrower gives to the Bank as one of its few available sources of financing. The approach adopted in the model is more prudent and reflects the value the Bank assigns to the borrower based on its level of risk. Both lines of reasoning are justifiable. However, we consider the position adopted to be appropriate given its
Basel Committee on Banking Supervision (2006), "International Convergence of Capital Measurement and Capital Standards", Annex 11.
Document FN-568-1, pp. 8-9.
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prudential and conservative nature. In the context of a credit risk model, it is reasonable to assign a lower default probability reduction to countries with a higher risk profile. c. Securities market correlations 3.20
Correlations between default probabilities are a key element of the model. In general, there are two approaches for calibrating correlations between default probabilities: the structural approach and the reduced form approach. The structural approach is based on a microeconomic model that determines the conditions for default. In contrast, the reduced form approach assumes a specific functional relationship between the expected probability of default and the underlying factor. Typically, the underlying factor is derived from observable macroeconomic or financial variables. According to this approach, the dependence of each country’s financial condition on common underlying factors is the source of the correlation between default probabilities. It is important to select the underlying factor that is expected to present co-movements that are similar to those of the default probabilities for the countries. The Bank’s model follows the reduced form approach, taking the securities market indexes of each country as the underlying factor. Countries with no information are grouped with the most similar markets, as determined by Management. The selection of securities market indexes as the underlying factor is an empirical decision made after ruling out multiple alternatives, including the option of using sovereign debt market indicators. 3.
Severity of default a. Fixed average severity
The IDB’s capital adequacy model uses opportunity costs to estimate the loss given default (or severity of default), rather than assuming a direct loss of principal and interest. The loss corresponding to the opportunity costs is expressed as a percentage of the original exposure. This approach was taken from the IBRD’s risk adjusted allocation of capital (RAAC) model, which uses severity factors that differ by country: (i) 30% for IBRD borrowers only, (ii) 100% for International Development Association (IDA) borrowers only, and (iii) 50% for borrowers from both sources. If these factors are applied to the IDB portfolio, the severity of default would be on average 32%.25 Basel II recommends a severity of default of 50% for noncollateralized senior loans to commercial borrowers. Given the sovereign nature of most of the Bank’s borrowers, the severity of default should have an upper boundary of 50%. On the other hand, considering that the IDB portfolio is more concentrated than the IBRD portfolio, and that it can include up to 10% of private sector loans, a lower bound of 32% should be considered.
In order to tailor the model to the IDB, the following considerations were made: (i) 30% for IDB borrowers only, (ii) 100% for FSO borrowers only, and (iii) 50% for borrowers from both sources.
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The Bank’s model uses a value of 35% as the average severity of default.26 The reasons behind this decision are related to (i) the lack of data to analytically calibrate severity, and (ii) the credibility gained by using another MDB, in this case the IBRD, as a benchmark. From this standpoint, the decision on the severity parameter is considered prudent and simple.27 b. Severity incorporates concentration
The Bank has a highly concentrated loan portfolio. Accordingly, a capital charge must be assigned to take into account the risk of default by a country representing a large share of the loan portfolio. One way to address this problem is the granularity adjustment proposed by Basel II.28 The purpose of this adjustment is to recognize that a bank with an exposure characterized by coarse granularity (implying significant residual idiosyncratic risk) should require additional capital. In a similar way, the capital requirements of a bank with exposure of finer than the “typical” granularity should be less than average.
The Bank’s model proposes an alternative to the granularity adjustment method. It assumes a positive relationship between opportunity costs and the borrower’s share of the portfolio. In this context, the impact of default by a country representing a negligible share of the Bank’s portfolio would essentially be the lost interest income that would have been earned if the loan had been repaid on time. In contrast, the impact of default by a country representing an important share of the portfolio would be much more severe, including, for example, the possible negative perception of the Bank in the market, with the associated increase in borrowing costs. We consider that the Bank’s model reasonably captures the portfolio’s current concentration risk. However, it could be complemented by an explicit policy establishing a threshold for acceptable portfolio concentration. 29
Attainment of objectives
The objective of the credit risk model is to provide the necessary support to absorb volatility in returns and prevent the institution from becoming insolvent. In the specific case of the Bank, it is important that this support adjusts to changes in the region’s financial and economic conditions. The recommendation for a new capital adequacy model initially stipulated that:30
Accounting loan loss provisions are calculated with a severity assumption of 1.4%, which is consistent with the Bank’s loan loss history but inconsistent with the model’s assumptions.
Schuermann Til (2004) “What do we know about Loss Given Default?” in Credit Risk Models and Management 2nd Edition, London, UK: Risk Books, presents a detailed review of methodological estimation and modeling alternatives for commercial banking.
Basel Committee on Banking Supervision (2001) "The New Basel Capital Accord" Part 2, Section F: Calculation of IRB Granularity Adjustment to Capital.
As Document FN 568-1, FN 568-3 show Capital requirements are particularly sensitive to concentration. In this regard, in addition to a capital adequacy policy, the IBRD also has an explicit concentration policy.
Document FN-568, paragraph 25.
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“In order to create internally consistent financial policies, capable of adjusting the target amounts for provisions and capital adequacy as the portfolio quality changes, the Bank needed to develop a capital adequacy framework based on the modern view of the interrelation between capital adequacy and loan loss provisions, which is dependent on the underlying credit quality of the portfolio.” 3.26
Bearing this in mind, the evaluation of whether the model’s objective has been achieved is based on its ability to react to portfolio quality changes. Thus, it would be desirable for the model to provide a measure of capital adequacy that is directly related to the level of risk of the countries in the Region. Figure 3.2 depicts the downward trend in the required TELR since the policy was implemented, which follows the same trend as the region’s risk level (represented by the spread of the Emerging Markets Bond Index Plus (EMBI+) in Latin America). Therefore, the required TELR is able to adjust to the Region’s level of risk. Figure 3.2 Required TELR and EMBI+ in Latin America 32%
2004-I Required TELR (left)
EMBI+ LA (right bp)
Although the latter demonstrates that the model has achieved its objective since its initial implementation (during which time there has been a relative cyclical upswing in the region), it would be desirable to confirm that the model is capable of attaining its objective during periods of crisis also. Simulations using the benchmark model described below confirm this condition laterally.
Subsequent to development of the Bank’s credit risk model, the Finance Department developed a benchmark model by adapting Basel II to the Bank, considering for such purposes: the same probabilities of default, the same preferred creditor status adjustment, the same severity assumption, and the same exposure at default.31 However, the benchmark model uses the granularity adjustment
See for example: Basel Committee on Banking Supervision (2006) "Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework - Comprehensive Version". The construction, assumptions, and details are fully documented in this and other documents available on the Bank for International Settlements website (www.bis.org).
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recommended by the Basel Committee on Banking Supervision to account for portfolio concentration and uses data aggregated by country. The benchmark model does not use Monte Carlo simulations. Instead, it directly calculates capital requirements (net of provisions) as 8% of risk-weighted assets. 32 3.29
This benchmark model is not used by the Finance Department to calculate the required TELR. It is an additional tool that enables scenarios to be validated and explored immediately, approximately, and coarsely.33 However, as shown in figure 3.3, the benchmark model and the Bank’s credit risk model both provide very similar results for the required TELR. Figure 3.3 Required TELR in the Benchmark Model versus the Bank’s Credit Risk Model 35% 30% 25% 20% 15% 10% 5% 0% 2003-II
2004-I Bank’s model
The similarities between both approximations confirm the orders of magnitude of the Bank’s credit-risk bearing capacity. In this sense, the Bank’s model is consistent with the recommendations of regulators for internationally active banks.
One of the main differences between the Bank’s credit risk model and the benchmark model is in the aggregation method. The former uses data disaggregated by loan and a risk indicator disaggregated by country, while the latter uses data and risk indicator broken down by country. Accordingly, similarities between the two point to a marginal reduction in risk resulting from risk diversification within countries. Another notable difference is related to the level of detail in available documentation. The Bank’s credit risk model could be better documented. More
The ratio of risk weighted assets to capital is known as the Cooke’s Ratio. Since the first Basle Accord in 1988 the minimum requirement for this ratio was set at 8%. The weights initially depended solely on the type of loan (i.e. sovereign, interbank, mortgage or commercial).
The required TELR is obtained as the immediate result of entering aggregated information on each country’s OLB on a worksheet. Simulation times are substantially shorter with the benchmark model.
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detailed information could be supplied on its operation or assumptions, following the documentation standard of the benchmark model or the IBRD model.34 F.
The Bank’s credit risk model has been subject to extensive simulations. Its sensitivity to a range of assumptions has been simulated, most notably to assumptions of severity, concentration, preferred creditor status, risk ratings, and a series of combined effects.35 From these simulations, we can conclude that capital requirements are more sensitive to severity and concentration assumptions, while economic loan loss provisions requirements are more sensitive to risk rating adjustments. In all cases, the model behaves as expected.
In order to check the model’s sensitivity to severity in a broader range than the simulations reported to the Board, a simulation exercise was carried out with the Bank’s credit risk model considering severity levels between 25% and 45%. Likewise, a sensitivity analysis on risk ratings was performed, maintaining severity at the fixed average level of 35%. This was done using the worst historical risk rating for each country of the Region. Results of both are summarized in figure 3.4 below. Figure 3.4 Required TELR 50% 45% 40%
TELR Benchmark model
30% 25% 20% 15% 10% 25%
As shown in the figure, the required TELR behaves satisfactorily. A direct and linear relationship between the required TELR and severity is also confirmed. Moreover, when each country’s worst historical risk rating is used, the required TELR is still within the expected ranges in the band proposed in the capital adequacy and loan charge policy. These simulations, together with those previously
IBRD (1998), “IBRD’s Risk-Adjusted Allocation of Capital Framework”. In the case of the IDB, the most detailed description is found in the series of FN-568 reports and in a document prepared by Netrisk that is less detailed than Basel II or the IBRD model.
Document FN-568-1; FN-568-3 Rev.
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reported to the Board highlight the importance of severity and, consequently, the concentration of the Bank’s portfolio in determining capital requirements. G.
Results of the evaluation
The model evaluated uses acceptable assumptions, there is consistency with the Bank’s risk profile, and prudence is the key factor for resolving subjective elements. Since the Bank does not discriminate in its loan charges to countries in the Region, the model relies on a greater level of prudence, so that the capital can absorb the entire effect of risk not transferred to the loan charges.
The Bank recently adopted new operating guidelines oriented toward expanding its lending program. The expansion will include the financing of operations for private companies in economic sectors that were previously restricted, and for subnationals without sovereign guarantees. The model is capable of incorporating the change in credit risk resulting from events of this kind.
The model’s objective of reacting to changes in portfolio quality is achieved both in periods of economic booms (which has been the case from initial implementation to the present) and in periods of economic crisis (simulated). IV. EVALUATION OF THE POLICY
The strategy for evaluating the policy consists of the following phases: description of the previous policy (as a point of reference), description of the current policy (the subject of the evaluation), analysis of the current policy, and report of the results of the evaluation. Annex 2 also presents an analysis of the compatibility of the policy under evaluation with some of the Bank’s main financial policies.
Description of the previous policy: 1990-2002
The previous policy set the charges based on two criteria: the net income target and the capital adequacy measure. The net income target was intended to set a level of net income that would permit the Bank (i) to cover current expenses in the context of changing financial markets, and (ii) to accumulate reserves as a way to protect debtholders and equityholders of the Bank of potential unexpected losses. Bearing this in mind, the net income target was set such that the interest coverage ratio (ICR) reached the level of 1.25.36 It was estimated that the level of 1.25 would allow the Bank to generate sufficient income to cover all expenses and accumulate enough reserves each year.37
The instrument used by the Bank to achieve the aforementioned target was loan charges. The problem thus consisted of setting loan charges at a level consistent with net income that would permit the Bank to achieve the ICR target = 1.25. Given IN , where IN = net income and BC = borrowing cost. BC
ICR = 1 +
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that loan charges have a positive effect on income, loan charges were set based on the end-of-period ICR so that it would reach the target in the next period. 4.4
The capital adequacy policy stipulated that the RLR had to remain within a band of 20% to 25%.38 This ratio indicates the level of protection provided to equityholders in the event of unexpected losses and expresses the amount of available resources before the ordinary capital is used. This band was selected based on the financial policies implemented by similar supranational banks (i.e. IBRD and Asian Development Bank) rather than on an independent analysis of the risks assumed by the Bank.39 Loan charges were the instrument used by the Bank to ensure that this indicator remained within the established band. Loan charges and the RLR are positively related, through the net income and general reserve channels. 40
Description of the current policy: 2003-present
The need to develop a new capital adequacy policy was based on the fact that the previous policy recommended maximum waivers in times of crisis and on the fact that:41 “As early as 1998, financial projections –especially the impact of the $7.6 billion emergency lending program– indicated that three years of charging basic charges on the regular lending program (needed to maintain the Reserve to Loans Ratio (RLR) close to the current policy minimum), five years of earning 400 basis points on emergency loans, and a leveling of the outstanding loan balance due to repayment of emergency loans in 2002 and 2003 would cause the RLR to exceed the current policy upper boundary of 25% by 2004-2005. Management believed that it was essential to have an analytical underpinning on which to base any recommendations for future actions once the upper boundary was reached. The RLR requirement, as an administratively determined band, would not be able to serve that purpose.”
The new policy requires the use of a new measure of capital adequacy: the TELR, which expresses the amount of available resources before making a call on callable capital.42 The new capital adequacy policy also defines standard loan charges: a lending spread of 30 basis points, a credit fee of 25 basis points, and an inspection
GR + SR , where GR = general reserve, SR = special reserve, OLB = outstanding loan balance, and OLB − ALL
ALL = allowance for loan losses. 39
Document FN-415-1. Anecdotally, the Asian Development Bank defined its policy during the same period and in the same way, but using the IDB as a reference.
Higher loan charges produce an increase in net income, which, in turn, increases the general reserve. Consequently, the RLR increases.
Document FN-568-3 Rev, paragraph 1.2.
GR + PI + ALL , where PI = paid-in capital and PV(guar) = present value of guarantees. OLB + VP( guar )
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and supervision fee of 0 basis points.43 These charges represent an equivalent lending spread of 44 basis points and ensure that, provided the TELR is within a reasonable range and some additional regularity conditions are satisfied, the Bank will generate sufficient income to cover the borrowing expenses and increase its stock of capital over time. Table 4.1 summarizes the new capital adequacy and loan charge pricing policy for ordinary capital.44 Table 4.1 capital adequacy and loan charge policy Standard charges are applied when: (i) 32% ≤ TELR ≤ 38%, and (ii) Net income is projected to be positive, and (iii) TELR is projected to grow in the medium term Additional charges would be required if: (i) Net income is projected to be negative, or (ii) TELR is projected to decline in the medium-term (iii) TELR < 32%: decision on a case-by-case basis.
The 32% lower bound was set as the required TELR which results when the inputs of the model include information characterizing the Bank’s situation in 2003. This could be interpreted as an early warning of insufficient capital. The 38% upper bound is the target level the Bank expects to achieve in the medium term and represents a level of capital that is sufficient to cover the risk associated with a broad range of possible severe events.45 It is important to emphasize that the value of the model resides precisely in the stress analysis that determined the 38% upper bound, the capital required in extreme but possible conditions. This should not be confused with the current required TELR, which is also provided by the model but refers to the capital requirements under the current risk conditions. Current risk conditions are not necessarily extreme conditions. The policy, therefore, is independent of the current required TELR.
Standard charges represent:46 “Management’s best judgment regarding the level of loan charges to enable the Bank to generate sufficient income to continue accumulating reserves towards the desired 38% even after experiencing financial stress, without overcharging the borrowers.” Standard charges were subject to stress to show that they are consistent with a level of accumulation of reserves that allows a TELR of 38% to be achieved in the next
Document FN-568-3 Rev, paragraph 5.11.
Table 2 is taken from document FN-568-3 Rev, page 16.
The list of all events tested in the model is found in document FN-568-3 Rev.
Document FN-568-3 Rev, paragraph 1.9.
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years (the target was expected to be reached in about 2008, but it was reached recently).47 C.
Analysis of the current policy 1. Determining factors of a loan charge policy
A minimum level of capital to allow the Bank to lend in times of need is an important goal that should be achieved lending at levels compatible with both the lending authority and the Bank’s risk-bearing capacity. 48 For planning purposes, the lending authority is embedded in the sustainable level of lending (SLL) and the risk-bearing capacity in the capital adequacy policy.49 The SLL represents the annual level of lending that could be sustained indefinitely (on the basis of projected approvals, disbursements, and repayments), such that the Bank’s lending authority is not exceeded, considering a security buffer. Based on Management’s recent calculations that level is US$7.6 billion.50
Loan charges are a key variable within the Bank’s policies. They are an important tool and affect a number of variables of interest. In addition to capital adequacy and lending authority, the loan charge policy needs to consider a series of additional factors and related variables, such as the macroeconomic conditions in the region; characteristics of the financial products offered; financial costs in other MDBs, in commercial banks, and in the capital markets; transaction costs; and the characteristics of recent operations in the sovereign debt markets by the borrowing countries. Management should provide the Board with relevant information on all these variables, including their current and projected levels and their sensitivity to loan charges. In this way, loan charges would be set, taking into account their overall effect on all relevant aspects for the Bank. The current loan charge policy focuses exclusively on capital adequacy. Thus, it would be feasible to increase the quality and relevance of the information provided to the Board for the determination of loan charges. 2. Importance of transaction costs
The total cost of loans is the classic tool used in the Bank’s financial policies. It comprises both financial costs and transaction costs. Financial costs refer to the rate the Bank charges on its loans and can be directly quantified. Transaction costs are costs incurred by the Bank’s borrowers associated with loan origination, the timing and conditionality of disbursements, fiduciary control, and the monitoring and supervision of operations. An approximate measure of transaction costs should
Document FN-568-3 Rev, paragraph 7.9. figure 12.
Document FN-568-3 Rev, paragraph 5.3.
The SLL was adopted by the Bank as a planning tool in 1994. The IBRD has used this methodology since 1976, and has documented it in "Sustainable Level of Lending. Technical Note" SecM84-789 of September 1984, among others.
Document CS-3347, CS-3692, FN602-1.
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include man-hours of negotiation, supervision and oversight, and the opportunity cost of delays in disbursements and uncertainty over financial costs. The amount of transaction costs varies by financial instrument and by country. Evidently, if transactions costs are important, the Bank might be very competitive in terms of financial costs and at the same time not very competitive in terms of total costs. While transaction costs are not directly managed like financial costs, they are equally relevant to the decision to borrow from the Bank, and Management should work to provide the Board with information on such costs as background for the discussion on setting financial charges. 3. Value-added 4.12
The structure of the current policy is very similar to the previous one, as shown in table 4.2. Table 4.2 Comparison of capital adequacy policies
Capital adequacy ratio Charges Income Loans
Current policy TELR (band) Standard, based on TELR Must be positive Lend.Aut.+ TELR
Previous policy RLR (band) Variable, based on RLR and ICR Target Lend.Aut + RLR
The new capital adequacy measure (TELR) and the previous one (RLR) are also closely related, particularly during the policy design phase (1997-2001), as shown in figure 4.1.51 These capital adequacy measures began to differentiate in 2002 due to changes in the accounting treatment of provisions and the reduction in demand for loans by countries in the Region.52
RLR PI + ALL , where Îľ = RLR [VP ( guar ) + ALL ] approaches zero (for 2003, 2004, and + GR + SR 1 + Îľ OLB + VP( guar )
2005 this expression has values of 0.0036, 0.0040, and 0.0039, respectively) 52
The reduction in demand for loans causes the OLB to decline, thus increasing the second term of the TELR shown in the previous footnote.
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Figure 4.1 Comparison of Capital Adequacy Policies 43% 38% 33% 28% 23% 18% 1996
Formally, the new policy also defines a band, is based on a capital adequacy measure that virtually replicates the behavior of the former, and eliminates the net income target as a criterion for setting loan charges. In both cases, indeterminacy arises when the ratio exceeds the upper bound. In the previous policy, the RLR had to always remain within the band. In contrast, the new policy defines standard charges when the TELR is inside the established band, projected net income is positive, and the projected TELR is rising. Outside the band, or in the absence of either of the other two conditions, the policy is discretionary. Discretion is exercised by the Board.
Under the previous policy, the RLR band was selected by taking into consideration benchmark values based on the capital positions of other supranationals similar to the Bank. In contrast, the new policy assigns a precise required capital adequacy ratio (TELR = 38%) based on the stress analysis of the Bankâ€™s credit risk profile.
The new policy replaces two previous policies. It replaces the previous loan charge policy and the previous capital adequacy policy. It eliminates the net income target as a criterion for determining loan charges. It also replaces the net income target with a set of conditions for the stability of the loan charges. The stability conditions arise from an analytical model of credit risk. However, the structure of the policy and the capital adequacy measure are both very similar to the previous ones. 4. Attainment of proposed objectives
Following is a list of each of the proposed policy objectives and a brief summary of their degree of achievement three years after the policy was introduced. a. Stability of loan charges53
As depicted in figure 4.2, the Bankâ€™s loan charges have been much more stable than in prior periods as a result of the new policy. In fact, standard charges have been
While not listed under the goals of document FN-568-3 Rev, this is explicitly mentioned as a goal in paragraph 7.33 of that document.
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consistently applied since the second half of 2003, with the exception of the last two semesters. The reason for this was that the TELR was close to the upper bound of 38%. In light of these circumstances, the Board considered it appropriate to reduce the charges to: a lending spread of 10 basis points, a commitment fee of 10 basis points, and an inspection and supervision fee of 0 basis points, which together represent an equivalent lending spread of 15 basis points. Figure 4.2 Loan Charges (equivalent lending spread in basic point)
200 150 100 50 0 1990-I1991-I 1992-I1993-I 1994-I1995-I 1996-I1997-I 1998-I1999-I 2000-I 2001-I 2002-I 2003-I 2004-I 2005-I 2006-I
To illustrate this, figure 4.3 presents the moving volatility of the Bankâ€™s loan charges.54 The figure depicts the downward trend in the volatility of loan charges since the new policy was introduced, although the level of volatility between 1999 and 2001, when charges remained constant (see figure 4.2), has not yet been recovered. Figure 4.3 Moving volatility of loan charges 0.7% 0.6% 0.5% 0.4% 0.3% 0.2% 0.1% 1993-I 1994-I 1995-I 1996-I 1997-I 1998-I 1999-I 2000-I 2001-I 2002-I 2003-I 2004-I 2005-I 2006-I
Moving volatility is calculated as the standard deviation of loan charges over the last six semiannual periods.
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Although it is still early to reach a conclusion, in the period following the introduction of the capital adequacy and loan charge policy, the objective of reducing the volatility of the Bank’s loan charges was satisfactorily achieved. Loan charges have shown greater stability than in prior periods. b. Policy founded in a risk-based framework
This objective is closely related to the credit risk model. As shown in the preceding section, the model’s structure is compatible with best industry practices and is, in general, reasonable. Insofar as the model provides an adequate estimate of the loss distribution, it will allow the measurement of the credit risk of the loan portfolio and of the risk that can be absorbed by the capital of the Bank.. Therefore, we consider that this objective has been satisfactorily achieved through the construction of the credit risk model. c. Continue lending to countries in times of need
The role of the Bank as the “lender of last resort” can be characterized from the point of view of the countries in the Region as liquidity insurance or as a low-cost contingent line of credit. The value of this option (i.e. the quality of the liquidity insurance) as well as the Bank’s acyclical role has become evident during different crises in the Region. If during recent crises this option has proven to be of limited value, it is only natural that the reaction of the countries has been to seek selfinsurance and differentiation through the accumulation of international reserves and higher diversification of financing sources in the current favorable economic conditions of the Region.
Only a sufficiently high level of capital in relation to the borrower’s potential credit requirements can ensure that the Bank continues lending even when extreme events occur. In general, that leads to setting conservative levels of capital adequacy and liquidity, consistent with each other, defined in terms of both a stock variable (e.g. the OLB) and in terms of the size of the potential events that may occur. Based on the stress analysis performed on the Bank’s credit risk model, the capital adequacy level to be achieved in the medium term implies a TELR of 38%.
An analysis of variance determined that only 24% of the capital adequacy measure used by the Bank (TELR) is explained by the variance in capital (numerator), while 28% is attributable to the variance in loans and guarantees (denominator), and 48% to the correlation between the two. This result shows that both the variance in capital and the lending level account for a significant portion of the capital adequacy measure. Moreover, the correlation between the two explains virtually one half of the variance. That is, the successful achievement of the target level of capital (38%) is largely due to the reduction in the lending level. This is not a consequence of the policy, but rather a response to the reduction in demand for loans by the countries of the Region.
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We believe it is still too early to assess the achievement of this objective, although it will become evident in future periods of turbulence in the Region, when the costs of private financing are higher and demand for Bank loans increases.55 d. Simple and transparent
Simplicity and transparency are key elements for the implementation and accountability of any policy. We consider that this objective has been partially achieved and that there is room for improvement in this direction. One weakness of the policy is that it stipulates as one of the conditions to set standard charges that the TELR must remain within a band of 32% to 38%, but does not precisely define what measure of the TELR should be used. This has led to confusion and disagreement when defining lending rates:56 “There was considerable discussion on how and when the TELR should be measured. According to some Directors, it should be based on the average observed TELR in recent months, according to an agreed calculation formula. According to Management, it should be based on the year-end figure, given the TELR’s tendency to fluctuate during the year, and in particular to its downward trend during the second semester.” The discussion was necessary because the policy does not provide a clear and transparent definition of what measure should be used.
In this regard, the loan charge policy, specially outside the band, should incorporate all the information deemed convenient, including the possible feedback effects and projections for relevant markets. The definition of the sufficient information set for the Board to best exercise its discretion is still a pending task.
Further, one way to increase the transparency of the policy execution is to fully observe the principle of separation of duties.57 Currently, the Strategic Financial Planning, Policy and Risk Management Division (SPR) identifies, develops, and proposes new financial products and policies through its Financial Policy Section (FPS), and at the same time implements financial policies through its Strategic Risk Management and Financial Planning Section (RMP).58 The fact that the same Division performs both functions reduces transparency and violates best control practices.
In this regard, Fitch Ibca (1999) “Risk Analysis of Multilateral Development Banks and other Supranationals” argues that, “Historically, multilaterals have often been the only source of new lending in a period of financial distress.”
Minutes of the meeting held on 4 May 2006, paragraph 1.4.
This principle corresponds to Principle 14 of the Basel Core Principles of 1999 and Principle 17 in the current exposure draft. See: Basel Committee on Banking Supervision (2006) “Comparison between the 1999 and 2006 versions of Core Principles Methodology”.
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Results of the evaluation
This section presents the results of the evaluation of the Bankâ€™s capital adequacy and loan charge policy in terms of its relevance, effectiveness, outcomes, and strategic approach. 1. Relevance
The new capital adequacy measure (TELR) mimics the previous one (RLR). The band-based policy structure also matches the previous policy. The significance and value-added of the new policy is the elimination of the net income target and the definition of the acceptable thresholds of credit risk. The new policy consolidates the capital adequacy and loan charge policies by using a band for the capital adequacy indicator as one of the stability criteria for loan charges. 2. Effectiveness
The policy has been effective in achieving most of the proposed objectives. It resolved the previous inconsistencies between the loan charge policy and the capital adequacy policy. In the period under review, the inconsistency was resolved by establishing a set of conditions for setting standard charges. Moving forward, the information requirements for the Board to best exercise its discretion still need to be determined. 3. Outcomes
A policy was defined in a risk-management based framework. In addition, more stable loan charges compared to prior periods were achieved, and the TELR target of 38% was met even earlier than envisaged, albeit due to lower OLB. 4. Strategic approach
The reduction in loans, which explains how a TELR of 38% was reached before than expected, could be the result of a significant change in the pattern of competition faced by the Bank. International banks and private pension systems currently have an important presence in the Regionâ€™s local financial markets and maintain unprecedented levels of sovereign risk in their portfolios. The governments of the Region have also registered significantly greater activity in the markets and have substantially replaced external debt with internal debt. Moreover, the international reserves of countries of the Region have grown significantly in the current international market conditions. Loan charge setting should take into account these changing market conditions.
Capital adequacy and loan charges are surely related issues, but they are different in nature. The former deals with determining the Bankâ€™s risk-bearing capacity, while the latter deals with determining a spread margin over cost that will allow the business to be sustainable, satisfying its statutory limits and fulfilling its mission. Using a consolidated loan charge and capital adequacy policy and focusing the analysis into a single internal variable, could ignore a number of additional
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variables of interest to the Bank. The different nature of the pricing and capital adequacy problems might require the use of separate policies. 4.35
The capital adequacy policy should establish the minimum level of capital that is prudent, reasonable and consistent with an appropriate measure of the Bank’s credit risk, and, consequently, with a level of capital that protects the Bank from a range of extreme, but possible, conditions. This minimum level of capital corresponds to a TELR of 38%, expected to be reached in the medium term, but already been reached. For strategic reasons, the loan charge policy should essentially be a discretionary policy and define—in addition to the required conditions for standard loan charges—the relevant information set that should be provided to the Board for the proper exercise of its discretion, considering all variables of interest. In particular, variables associated with total costs and the market conditions of the sovereign debt of the countries in the Region. V.
FINANCIAL AND OPERATIONAL IMPACTS
The Bank’s AAA credit rating is due to its callable capital, preferred creditor status, and prudent financial policies. The policy under evaluation prudently complements the range of financial policies and, accordingly, favors maintaining the AAA rating.
The most significant financial impact has been higher loan charges than those that would have been set under the previous policy. As shown in figure 5.1, in 2003 the ICR doubled the target ICR. In subsequent years, it has remained far above the target of 1.25 established in the previous policy.59 Likewise, in 2003, the RLR exceeded the upper boundary of 25% and remained above that limit in subsequent years. Figure 5.1 Previous Policy 2.6
15% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 ICR
The 2003 jump in the ICR is due to the change in the accounting methodology for registering loan loss provisions. However, even considering that effect, the reduction in loan charges would have been required had the previous policy been maintained.
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In order to drastically reduce the ICR, it would have been necessary to reduce the charges to maximum waivers. Accordingly, we can infer that under the previous policy, charges since 2003 would have consisted of maximum waivers.
One of the virtues of the previous policy is that it was well defined, requiring the RLR to be inside a band, and stipulating that the ICR had to reach the target level of 1.25. Thus, in any circumstance, loan charges had to be set based on the distance of these observed key variables and their respective targets. As mentioned above, the current policy is discretionary when the TELR is outside the band, and the relevant information set to properly exercise such discretion has not been fully defined. This has led to extensive discussions for setting loan charges in the last two semesters.60
Therefore, the main operational impact has been the difficulty in reaching consensus. Disagreements and delays arise from trying to tie loan charges to capital requirements. Although the Bank’s capital adequacy and loan charge policies are certainly related, the relationship is neither simple nor direct. The relationship between the capital adequacy policy and the Bank’s pricing policy contains an important strategic component that should make them compatible. For this reason, the information used as the basis for setting loan charges needs to be substantially expanded. VI. CONCLUSIONS AND RECOMMENDATIONS
This document provides a historical overview of the Bank’s capital adequacy and loan charge policy, and evaluates the current loan charge and capital adequacy model and policy. It also documents the main financial and operational impacts of the policy.
The model is acceptable and reflects the Bank’s risk profile. The structure is consistent with the one proposed by Basel II and with the main credit risk models for commercial banking. The Bank’s particular characteristics, such as non price differentiation, preferred creditor status and concentration, are taken into account in a reasonable manner. Most of the assumptions are adequate, although several could be improved. Since its implementation in 2003, in the context of favorable economic conditions in the Region, the required capital adequacy measure has trended downwards. Likewise, through simulations it was shown that the model responds reasonably to adverse changes in the economic and financial conditions of the Region.
The policy is essentially a loan charge policy and a capital adequacy policy consolidated in one, that includes a set of stability conditions, outside of which the setting of loan charges is discretionary. The relevance of the new policy lies in the
See minutes of the meeting held on 4 May, 2006.
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elimination of the net income target and in a more accurate estimation of the Bank’s risk exposure. The policy has been effective in achieving the proposed objectives. A policy was defined in a risk based framework, greater stability was achieved in loan charges compared to previous periods, and the TELR reached its medium term target of 38% even earlier than planned (although this was largely due to a decrease in lending. 6.4
The main financial impact was the elimination of the net income target (ICR) for setting loan charges. Elimination of that target has permitted higher loan charges than those that would have been set under the previous policy. Another financial impact was the better perception of the Bank by the rating agencies, although the capital policy was not a crucial factor in maintaining the AAA credit rating.
The main operational impact is the difficulty in reaching consensus regarding appropriate loan charges now that the capital adequacy measure has exceeded the range defined by policy. In this environment, the Board needs information beyond that provided by the level of capital in order to make good strategic decisions on loan charges.
The capital adequacy policy has worked well during the first three years of its application; it has achieved most of its main objectives, and has the virtue of being well understood by the Bank’s shareholders. However, in the context of the Bank’s evolving business model, there are some areas in which some improvements could be considered.
The credit risk model is the result of a development effort that should be a permanent activity. Accordingly, the necessary resources should be assigned for the model to be permanently updated and based on the most recent experience and developments in risk management and information technology. To move in that direction, the following recommendations are made: (i) explore the possibility of using new sources for calibrating the probabilities of default, and (ii) explore the possibility of migrating to a conditional model that explicitly incorporates macroeconomic and/or financial variables for each country. Furthermore, tighter coordination is recommended between the areas responsible for development of the model and the Bank’s Research Department. Finally, improvements in the model’s standards of documentation are also recommended.
Linking the loan charges to the TELR has helped produce the desired stability and has rapidly strengthened the Bank’s capital position. However, in the current circumstances, with a TELR above 38%, the current policy does not provide sufficient guidance for the Board to exercise its discretion in setting loan charges. In this new context, and given more competitive capital markets, the Bank could consider separating the capital adequacy and loan charge policy into two separate policies.
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The capital adequacy policy could establish the minimum level of capital that would be prudently acceptable and that would allow the Bankâ€™s mandate to be exercised even in extreme conditions. This minimum level of capital corresponds to a TELR of 38%, which was expected to be reached in the medium term. It might also be convenient to complement the capital adequacy policy with an explicit concentration threshold, as is currently done in the World Bank. Additionally, separating the functions of financial policy development and financial policy implementation would allow greater transparency and would also allow better compliance with best practices and control principles.
For strategic reasons, the loan charge policy could be defined so that it is essentially a discretionary policy that prioritizes stability, and that defines the necessary information set to enable the Board to exercise its discretion, taking into account all the variables of interest. Ideally, this information set would include, in addition to the capital adequacy level, the current and expected conditions in relevant markets. In particular, variables associated with the total cost of the Bankâ€™s products (including transaction costs) and the market conditions of the sovereign debt of the countries of the Region should be considered.
Annex I Page 1 of 6
The role of capital
In the context of commercial banking, bank risk is typically defined as the volatility of returns. This volatility implies potential losses, which imposes the need for sufficient capital to cover their potential realization. The situation is similar for the IDB, except that as a self-regulated institution valued for its capacity to lend in times of crisis, capital requirements are substantially greater. The conventional way to measure the risk of a financial institution is value-at-risk (VaR), defined as the amount of capital required to protect the Bank against volatility of returns, up to a given level of statistical tolerance.61 Inclusion of a level of statistical tolerance is required to the extent that volatility is not a sufficient statistic to characterize the distribution of returns. The VaR method standardizes volatility to a statistical tolerance level, in order to make risks arising from different factors comparable. In this way, different types of risks, with different distributions, can be measured equivalently at the same statistical tolerance level, and can be eventually aggregated. In order to apply the VaR method, extreme events must be identifiable in the distribution tails for each type of risk. Aggregation of all these types of risks provides the aggregated loss distribution that should be used to calculate capital. Based on the lessons learned from the crisis of the 1980s mentioned in the background section, it is crucial to consider the correlation between risks at the time they are aggregated. B.
Risk management technology
The level of risk management technology can be described as a function of two factors: (i) the ability to quantify risk and (ii) the ability to disaggregate risk. In one hand, to the extent that a risk is quantifiable, it is more feasible to propose a specific numerical policy.62 In the other hand, when a risk can be disaggregated, its identification, measurement, and control become more feasible. In response to various crises in financial institutions, risk management techniques have evolved over time, in tandem with capital adequacy models. This is clearly seen with the evolution of the Basel Accord. In 1988, the original Basel Accord (Basel I) focused mainly on credit risk management. In order to incorporate market risks, the 1996 amendment to the Basel I framework assigned an explicit capital charge to the price of the transactional risk of certain operations. The recently adopted New Basel Accord (Basel II) considers operational risk as a specific category of nonfinancial risk, and imposes a new capital charge to cover this type of loss. 61
The IDB uses a statistical tolerance of 99.89%.
By "numerical policy" we mean a policy that includes an explicit value, such as the case of the current capital adequacy policy, which stipulates as one of the regularity conditions for setting standard charges that the capital adequacy measure must fall within a band of two specific values: 32% and 38%.
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In general, all financial institutions are subject to the following risks: market risk, credit risk, asset/liability risk, operational risk, and strategic risk. The first three are financial risks and are associated mainly with financial institutions, while the last two correspond to nonfinancial risks and are common to all types of institutions. Following is a brief description of each type of risk, as well as a summary of their current level of risk management technology. 1.
This type of risk is associated with adverse variations in the prices of financial instruments related to the Bankâ€™s operations. The VaR method was originally developed to quantify market risk, and currently most financial institutions use it to calculate the risk of their financial positions on a daily basis. Because high-frequency historical data are now easily accessible for most exchange rates, interest rates, stock prices, etc., this type of risk is relatively easy to quantify using the VaR method. This risk is also easy to disaggregate, since the marginal impact on the VaR of each transaction can be determined in a straight-forward way. For that reason, under Basel I, banks were only allowed to use their own internal models for market risk. 2.
This type of risk is associated with potential losses arising from borrowers defaulting on their obligations. At the transaction level, the internal ratings-based method is the most widely used to calculate expected losses on the basis of three key elements: probability of default (P), severity given default (S), and exposure to default (E). At the portfolio level, various models have been proposed by the industry to calculate correlations in default probabilities from a structural standpoint. As in the case of market risk, this type of risk is easy to disaggregate, since the degree of credit risk can be calculated for each loan. However, in contrast to market risk, default is an infrequent event and, therefore, the historic availability of realizations of defaults is limited. This implies a low degree of precision in the calculation and quantification of credit risk. In addition, default probabilities vary with the economic cycle, and this should be captured by any realistic credit risk model. 3.
This type of risk refers to the possible generation of losses due to variations in interest rates on the Bankâ€™s asset and liability positions. While related to market risk, this type of risk is much more difficult to quantify. There is consensus on how to model and predict variations in interest rates. However, in order to estimate the effect of those variations, the mismatch between asset and liability flows must also be estimated. This requires an estimation of the duration of liabilities of an unspecified maturity, for which the effective maturity could exceed the contractual maturity. Disaggregation is feasible up to the level of groups of transactions by type of loan, but the level of disaggregation is therefore lower than the level for market or credit risk.
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In this regard, Basel II reports that the lack of consensus on measuring asset/liability risk is the main reason that this risk did not generate an explicit capital charge in Pillar I, but is instead covered by Pillar II. 4.
Basel II defines “operational risk as the risk of losses resulting from inadequate or failed internal processes, people, and systems, or external events”. This definition includes legal risk (...). It does not, however, include strategic or reputational risk.” In addition to providing a standard definition for this type of risk, Basel II proposes a framework for risk classification, subdividing internal and external events into seven recognized categories. However, it is still a challenge to tie operational risk to a capital charge given the extreme mass in the tails of its distribution. This is due to the fact that losses of this type correspond to very severe events that have a low frequency of occurrence and are rarely observed in a single institution. Although some authors have suggested the use of the extreme value theory to tie this risk to capital charges, quantification of this type of risk is still in a very preliminary stage. Moreover, given its association to extreme values, it is difficult to disaggregate. 5.
Strategic risk can be understood as a residual risk, i.e. as the possibility of losses not caused by any of the factors previously defined (credit, market, asset/liability, or operational). This type of risk is lies on the frontier of risk classification and measurement, and there is still no standard definition. In general, it includes all sources of nonfinancial income that cannot be directly attributed to failed internal processes or external events. Examples that can be classified in this category include: change in consumer preferences, technological changes, appearance of new competitors, shrinking of the industry margin, etc. Given its broad nature and recent appearance in the relevant literature, strategic risk is the most difficult to quantify and disaggregate.63 Figure I.1 summarizes the current comparative level of risk management technology. As observed, there is a clear scale in the existing technological level for managing each of the Bank’s type of risk exposure.
For a detailed explanation of this type of risk, see Slywotzky and Drzick (2005) “Countering the biggest risk of all”. Harvard Business Review.
Annex I Page 4 of 6 Figure I.1 Risk management technology by risk type
Technology Quantifiable Disaggregatable
Asset/ Operational liability risk risk
Risk management system
The Bankâ€™s risk management system is defined according to the different stages of the risk management process. In general, an integrated risk management system should have prevention measures, early corrective actions, and damage control mechanisms associated with the different stages of the risk management process. This approach should be applied to each type of risk, considering the interrelationship between them. Prevention measures are aimed at reducing the probability of occurrence of an adverse situation. Early corrective actions involve the use of instruments that allow the immediate impact of the disaster, if it occurs, to be reduced. Finally, when the impact of the disaster exceeds the scope of early corrective actions, the excess impact is addressed by applying the damage control mechanisms. In the case of financial institutions, prevention measures vary according to the type of risk for which they are designed. In contrast, early corrective actions are related to the level of provisions and the capital charge for all types of risk. However, the relative contribution of each type of risk to the level of provisions and the capital charge varies depending on the risk profile of each institution. Finally, damage control mechanisms are normally associated with a common emergency fund for all risks, which would be used in extreme cases in which early corrective actions are insufficient. Table I.1 presents the Bankâ€™s risk management system, in which each policy is grouped, based on the stage of the risk management process to which it belongs and the associated type of risk. It is important to emphasize that this system is the result of the evolution of the Bankâ€™s financial risk management practices, as reported in the Background section.
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Table I.1 IDB’s risk management system Market risk
Asset/liability risk Operational risk
Prevention Early corrective measures Damage control Interest rate risk Callable capital Foreign exchange risk Lending policy Loan loss provisioning policy Loan loss provisioning policy Callable capital Capital adequacy policy Capital adequacy policy Asset/liability management Callable capital Liquidity policy Internal control system Callable capital Disclosure and reporting policy
Callable capital works as an emergency fund that should only be used in extreme situations arising from any type of risk, when prevention and early corrective measures are insufficient to address the problem. Risk prevention measures are independent for each type of risk. For example, conservative lending policies that include a sovereign guarantee for 97% of the loan portfolio reduce the probability of losses arising from credit risk. Given that strategic risk is difficult to disaggregate and quantify, the Bank still does not have prevention measures or early corrective actions in place. In general, the Bank’s risk management system assigns greater emphasis on damage control measures and prevention than on early corrective actions. Specifically, the Bank does not consider market, asset/liability, operational, or strategic risks in the level of provisions or the capital charge. In this regard, when the new capital adequacy policy was proposed, it stipulated that:64 “Similar to other financial institutions, the Bank is exposed to market risk, operational risk, and credit risk. (...) by strictly adhering to a set of conservative investment guidelines and by effectively managing its assets and liabilities, the Bank has been able to maintain its market risk at negligible levels.(...) through internal controls, reporting layers, and oversight by the internal auditors, the Bank has been able to reduce and manage its overall operational risk. (...) Consequently, in the proposed capital adequacy framework, Management does not recommend specifically allocating capital to cover the Bank from either market risk or operational risk. In this manner, practically all of the Bank’s equity would be made available to protect the Bank from its credit risk exposure in its lending operations, which is by far the institution’s largest risk.” The above text clearly does not distinguish between the different stages of risk management. Arguments are made for effective prevention measures for market and 64
Document FN-568, paragraphs 43-45.
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operational risks, concluding that it is not necessary to consider early corrective actions for these types of risks. The role of equity is to absorb losses, given that they may occur, and regardless of the preventive measures taken. In the long term, it would be desirable to have a capital policy that is able of absorbing losses arising from various types of risk, and considers the interrelationship between them. As mentioned through this document, the Bank’s risk management system is fragmented, with functions assigned to the different units of the Bank’s Finance and Private Sector Departments. D.
Risk exposure and new trends
A “forward-looking” risk management system should be able of estimating the contribution of each type of risk to the volatility of the Bank’s returns. Related to this issue, Kuritzkes and Schuermann (2006) estimate the contribution of each type of risk to the volatility of net income of commercial banks in the United States as 6% for market risk, 46% for credit risk, 18% for asset/liability risk, 12% for operational risk, and 18% for strategic risk. 65 Based on these results, the authors conclude that the historical focus on management of market and credit risks, while important, only account for one half of the total risk exposure of commercial banks. They also find that inclusion of the interrelationship between the different types of risks reduces total risk by one third. The authors propose that improvements in risk management should focus on known risks that have the greatest impact on the volatility of earnings. Although there is currently no precise estimate of the contribution by type of risk to the volatility of the Bank’s return, it is feasible to associate the new economic and financial trends in the Region with the Bank’s risk exposure. In economic terms, the Region is currently facing a favorable environment, and the countries of the Region have reduced their demand for IDB loans, replacing it with private financing. This is due to a shift in demand from the countries of the Region. Clearly, strategic risk has gained a greater relative importance in recent years. The capital adequacy model and policy evaluated in this document are a first attempt to align the Bank’s risk management system with a structured model, given the existing technology. While the argument that operational risk and market risk do not require a capital charge is not technically accurate, we agree with Management that the type of risk that has historically caused the highest damage to the Bank is credit risk. In this sense, starting by considering only credit risk was sensible, realistic, and consistent with the economic and financial context in 2002 in which the new capital adequacy framework was proposed. Indeed, other MDBs, such as the IBRD, the European Bank for Reconstruction and Development, and the African Development Bank also consider only credit risk in calculating the loss distribution and related capital adequacy measures.
Kuritzkes and Schuermann (2006) “What we know, don’t know and can’t know about Bank Risk: A view from the Trenches” Working paper #06-05. Wharton Financial Institutions Center.
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COMPATIBILITY WITH OTHER POLICIES
An additional issue we consider relevant in the evaluation is the compatibility of the policy under evaluation with the Bank’s other main financial policies. A.
According to the Agreement Establishing the Bank, loans and guarantees may not exceed the sum of callable capital of the donor member countries (CC), paid-in capital (PI), and the general reserve (GR). This restriction is known as “lending authority” and can be expressed as follows: OLB + VP( guar ) ≤ PI + GR + CC
Using the definition of the TELR (paragraph 3.6), the previous equation can be reexpressed as:
PI + GR + SR + ALL =K, PI + GR + CC
such that the lending authority imposes a lower bound (K) on the TELR. Moreover, the current policy requires that the TELR to remain inside a band ( 0.32 < TELR < 0.38 ) as one of the regularity conditions needed to set standard charges. Since callable capital is much greater than the sum of the special reserve and provisions, it is natural to assume that K < 1. In addition, since all the variables present positive values, then K > 0. Consequently, in general, values between 0 and 1 will be assumed for K. The compatibility of both policies will depend on the relationship between the limits that each policy imposes on the TELR. Table II.1 describes the three possible scenarios and the implications for compatibility between both policies in each case.
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Table II.1 Compatibility scenarios with lending authority Scenario 1: K > 0.38 In this case, compatibility of the lending authority and the capital adequacy and loan charges policy would imply that TELR > K > 0.38 and 0.32 < TELR < 0.38 , respectively. Given that the intersection of both inequalities is empty, in this scenario the policies would be completely incompatible. In other words, compliance with one policy implies noncompliance with the other policy. Scenario 2: 0.32 < K < 0.38 In this scenario, both policies can be compatible only if K < TELR < 0.38 . Moreover, when 0.32 < TELR < K , the capital adequacy regularity condition of the policy is satisfied but the lending authority is not. In this latter case, the capital adequacy and loan charges policy (which was proposed after the lending authority) would have been incorrectly defined, since it should use a value greater than or equal to K as the lower boundary for the capital adequacy regularity condition (in this scenario, the value of 0.32 does not satisfy this condition) such that both policies are compatible. Scenario 3: K < 0.32 Finally, in this last scenario, the capital adequacy regularity condition of the policy is more restrictive than the lending authority, such that compliance with the former necessarily implies compliance with the latter ( K < 0.32 < TELR < 0.38 ). Therefore, it could be argued that the lending authority becomes redundant if compliance with the capital adequacy policy is assured.
To analyze the compatibility of both policies, figure II.1 shows the lower bound (K) of the Bankâ€™s lending authority in recent years. As shown, this value has remained far below the lower bound of the capital adequacy regularity condition of the policy, with an average of 24.57% < 32%. This corresponds to scenario 3 and we can conclude that both policies are compatible. Moreover, since the capital adequacy regularity condition of the policy is more restrictive than the lending authority, the latter is incorporated by the former. Figure II.1 Compatibility between this policy and the lending authority 40% 35% 30% 25% 20% 1996
Lower boundary (K)
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In July 2005, Management proposed a new ordinary capital liquidity policy, which was approved by the Board. One of the arguments made in proposing the new policy was that:66
“The Bank adopted a Capital Adequacy policy and associated lending rate methodology in 2003, immunizing its loan charges from changes in borrowing expenses.” As indicated, the proposal itself recognizes the impact of the capital adequacy policy on the Bank’s previous liquidity strategy. Thus, both policies are clearly related. The new ordinary capital liquidity policy stipulates that the levels of minimum and maximum annual liquidity are calculated as 20% and 40% of the projected year-end OLB, with a desired mean of 30%. The definition of liquidity (L) includes the Bank’s liquid investment portfolio, which comprises the special reserve and the Short-term Borrowing Facility and Discount Note Program (STBF/DNP), plus cash in convertible currencies.67 Thus, the ordinary capital liquidity policy implies that:
L < 0.4 OLB
Using the definition of the TELR, the latter equation can be reexpressed as: Qmin =
PI + GR + SR + ALL PI + GR + SR + ALL = Qmax , < TELR < L L + VP( guar ) + VP(guar ) 0 .2 0 .4
such that the liquidity policy implicitly imposes a band for the TELR. In contrast to the capital adequacy regularity condition of the policy, however, this band is variable. To analyze the compatibility of the policies, figure II.2 shows the bounds imposed by the liquidity policy in recent years, together with the thresholds of the capital adequacy regularity condition of the policy and the observed TELR. As shown, the lower bound has remained far below the policy’s regularity condition lower bound, with an average of 21.48% < 32%. However, the upper bound became active in 1999 and 2000. Given that the liquidity policy was not proposed until 2005 and does not currently intercepts the bands established for the TELR as a regularity condition, we consider both policies to be compatible.
The compatibility analysis assumes a projected OLB equivalent to the current OLB.
Annex II Page 4 of 6 Figure II.2 Compatibility between this policy and the liquidity policy 55% 50% 45% 40% 35% 30% 25% 20% 15% 1996
Another interesting issue for analysis is the relationship between liquidity and the TELR when both policies are fully compatible. In such a case, we would expect that Qmin = 0.32 and Qmax = 0.38 . Therefore, PI + GR + SR + ALL PI + GR + SR + ALL − VP( guar ) L = 0.2 − VP( guar ) = 0.4 0.32 0.38 and based on the last equality, we have: VP( guar ) = 2.14(PI + GR + SR + ALL )
Substituting this last expression in the preceding equation, we obtain a level of liquidity that is perfectly consistent with the capital adequacy policy ( L ), L = 0.2(PI + GR + SR + ALL ) This means that when full compatibility with the capital adequacy policy is imposed on the new liquidity policy, a target liquidity value is obtained rather than a band. Considering that the desired liquidity level takes the form of a fixed proportion α of the OLB in the new ordinary capital liquidity policy, it is possible to show that under the assumption of full compatibility of the policies, the TELR and α are related as follows: TELR =
1 0 .2
In the case of the new liquidity policy, α=0.3 was imposed as the desired measure, which is consistent with a TELR of 0.36. Figure II.3 shows how in the case of full compatibility of the policies, the OLB percentage set to determine liquidity (α) has a positive relationship with the TELR, assuming that all other variables remain constant.
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0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 0.01
Full compatibility between this policy and the liquidity policy
Although the policies are not fully compatible, figure II.4 shows that the historical TELR series and the ratio of liquidity to OLB present a positive correlation of 0.22. Figure II.4
TELR and Liquidity/OLB 0.39 0.37 0.35 0.33 0.31 0.29 0.27 0.25 1996
Finally, it is interesting to note that in the context of a future crisis that requires emergency lending, although the TELR would be decreased by the sharp increase in loans, since the bands are proportional to the OLB, the Bank would have a greater level of liquidity for financing those loans, given a specified alpha (current target is 0.3). Therefore, the capital adequacy and liquidity policies are not only compatible, but would also effectively complement one another in periods of crisis.
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New Lending Framework
During 2005, the Board approved a New Lending Framework (NLF), effective for the 2005-2008 period. The NLF is an attempt to adapt to new demand from the Region, which requires simpler operational processes, faster disbursements, and fewer lending conditions. The NLF maintains the three existing loan categories, but the minimum disbursement periods are eliminated for investment loans and policy-based loans. The NLF also enables the Bank to offer single-disbursement policy-based loans. Finally, the NLF establishes flexible annual lending operations for a cumulative amount of US$20.6 billion for investment loans and US$9.8 billion for policy-based lending, limiting outstanding emergency loans to US$6 billion. Given that the NLF alters the speed of disbursements and the composition of the Bank’s portfolio in terms of types of loans, it represents a significant change in inputs to the model. When the model was simulated in 2003, the NLF was not taken into consideration since it was still being designed. OVE considers it appropriate to modify the inputs to the model that was previously simulated in order to incorporate this new frequency of disbursements and portfolio composition. Once this information is incorporated, the required TELR value that was used as the basis before performing the stress analysis could vary significantly. D.
Loan loss provisioning policy
In 2004, the Bank modified its loan loss provisioning policy to bring it into line with generally accepted accounting principles (GAAP). GAAP provide important guidance on building ALL, requiring that a loss be provisioned only when default on an obligation is “probable” and when the amount of the loss can be “reasonably estimated”. According to the American Institute of Certified Public Accountants (AICPA), the estimate of loan losses should reflect losses that have already been incurred, and not losses that might be incurred over the remaining life of the loans (even if predictable based on historical experience). Given the Bank’s history and its preferred creditor status, there is a low probability of default on payment of principal or interest. However, the Bank has experienced delays in repayments by borrowers, in some cases of more than six months. Since the Bank does not charge interest on interest arrears on sovereign loans, such arrears in debt servicing can be viewed as a loss, given that the Bank is not compensated when payments are not made on the contractually agreed dates. The Bank’s new loan loss provisioning methodology is based on (i) the probability of default associated with the risk rating for each borrower obtained from external sources, (ii) the severity of historical default, estimated at 1.4%, and (iii) exposure to default, i.e. the OLB. There is clear incompatibility between the historical severity of 1.4% used to calculate provisions and the average severity of 35% assumed in the model. This apparent contradiction is due to the accounting restriction on the calculation of provisions, which must only be based on incurred losses.