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Emerging Europe faces Basel upheaval

There are major issues to iron out for EU emerging markets in adopting Basel II, warns the EBRD’s Piroska M. Nagy.
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Basel II is set to become reality in the EU at the end of 2006 and all evidence indicates that its impact in emerging Europe will be nothing short of a small revolution.

The biggest upheaval may come from the need to accelerate the gradual improvements in risk management practices. The impact on regulatory capital will also be important, despite the existence of sizeable ‘capital buffers’ in the region (capital exceeding the minimum requirements). The size of the change in regulatory capital will largely depend on the type of risk assessment approach that the banks will be able – or allowed by national supervisors – to use. For an average bank in the new EU member states, using the internal ratings-based system may be more advantageous than the standardised approach but it has demanding data, modelling and disclosure requirements.

Risk mitigation rewards

There are other important issues: emerging Europe hardly uses risk mitigation instruments. Yet Basel II will recognise more of these instruments and reward them more deeply by capital relief. Operational systems must be reviewed and upgraded to minimise the capital charge related to operational risks – a new capital charge under Basel II. Preparations for and implementation of Basel II are also costly: PricewaterhouseCoopers estimates costs between €80m and €150m for a large EU bank, proportionately less for smaller banks.

The home-host issue will also be important, given the high share of foreign banks in emerging Europe. Basel II gives supervisory leadership to the home supervisor (the supervisor of the parent bank). Although this makes sense from a global bank group’s point of view, it could have serious policy consequences in host countries. Local (host) supervisors in the region will still be legally responsible for their financial sector’s stability, but many of the supervisory instruments will be in the hands of parent banks’ supervisors.

A subsidiary could be systemically important for a host country but relatively insignificant financially to the parent bank, and thus to its home supervisor. For example, the share of foreign ownership in the banking sector is more than 90% in the Czech Republic, Estonia, the Slovak Republic and Croatia. But the typical share of a central European subsidiary bank in its parent bank’s total assets is, except for a couple of Austrian banks, less than 10%. Information sharing and co-ordination between home and host supervisors will be complex but resolvable. However, the issue of who provides emergency liquidity/ lender of last resort facilities to a systemically important subsidiary bank, and when, will remain wide open. The home-host issue is not just about information sharing but also about cost-sharing – a far more difficult matter.

Uneven preparations

Despite these potentially sweeping implications, preparations for Basel II are uneven across countries and raise a number of issues. First, there is a clear asymmetry in preparations depending on bank ownership: foreign-owned subsidiaries benefit from their parent’s leadership, guidance and cost coverage; locally-owned banks do not and thus can be disadvantaged. Second, preparations in Bulgaria and Romania lag behind because they have not received derogation from Brussels on introducing Basel II, and thus will have to implement it on their expected EU entry in early 2007.

Third, there will be potentially inefficient situations when foreign bank subsidiaries in host countries follow Basel II but national supervisory rules in the host country do not, such as in Croatia and Albania. Banks will be producing different figures and negotiating with both host and home supervisors under different regimes. And fourth, the IMF and the World Bank have taken the view that emerging markets should not rush to introduce Basel II, and they are not yet providing significant technical assistance. Yet in the EU, the adoption of Basel II will be compulsory. Other emerging non-EU countries may also want to become early members of the Basel II ‘club’. Helping banks and supervisors to prepare for, and to cope with, the consequences of Basel II, is an important and immediate task in which the European Bank for Reconstruction and Development (EBRD) is involved.

Piroska M. Nagy is a senior banker at the financial institutions business Group of the EBRD, responsible for financial sector regulatory issues.

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