Can international capital standards strengthen banks in emerging markets?

This paper deals with the appropriate design of capital adequacy requirements in emerging markets. It divides countries in two groups according to their capacity to enforce regulatory capital. The first group is characterized by an inappropriate accounting standards and reporting systems, improper classification of non-performing loans and deficient legal and judicial frameworks, and high concentration of asset ownership. It is shown that under these conditions, capital ratios can not perform their supervisory role of containing excessive risk-taking activities by banks. The sustainable policy for these countries consists of removing the constraints to the effectiveness of capital standards; however, those policy reforms often take a significant amount of time. During the transition period, it is essential to identify and develop indicators of banking problems that reveal the true riskiness of banks. Recommendations for policymakers, therefore, focus on strengthening the role of market discipline to substitute for the inadequacies of the regulatory capital requirements. In the second group of countries, a continuous increase in the participation of foreign banks from industrial countries is de facto reducing the degree of related-lending activities. The combination of competition induced by the entry of new providers of wealth and improved accounting, regulatory, and supervisory frameworks can contribute towards increasing the usefulness of capitalization ratios. The main recommendation for this group is to design a capital standard that appropriately reflects the risk of banks' assets. The standard should have two basic components. The first is the development of risk-based regulations in loan-loss provisions. The second is the establishment of a reduced number of risk categories to classify assets, with the central qualification being that the categories of risk should reflect the particular features of banks’ assets in emerging markets. Issues that need to be considered include an adequate risk assessment of government paper and the introduction of distinct capital charges for borrowers in the tradable and non-tradable sectors.