Financial crises, credit ratings, and bank failures : use of portfolio risk models and capital requirements in emerging markets : case of Argentina

 77389 the world bank economic review, vol. 16, no. 2 197–212 Financial Crises, Credit Ratings, and Bank Failures On the Use of Portfolio Risk Models and Capital Requirements in Emerging Markets: The Case of Argentina Veronica Balzarotti, Michael Falkenheim, and Andrew Powell A portfolio-based model (CreditRisk+ of Credit Suisse First Boston) and recent Cen- tral Bank of Argentina credit bureau data are used to estimate whether current capital and provisioning regulations match actual risks. Arguing that provisions should cover expected losses and that capital requirements should cover potential losses beyond expected losses subject to some statistical level of tolerance, the article assesses how well actual capital and provisioning requirements match the estimated requirements given by the model. Actual provisioning requirements were found to be close to im- plied levels of expected losses. The estimate of potential losses was found to be highly sensitive to the assumptions of the model, especially the parameter relating the volatil- ity of a loan’s rate of default to its mean value. This volatility parameter cannot be estimated accurately with the credit bureau data because of the short time span cov- ered, so proxy data were used to estimate it, and two values around that estimate were tried. The difficulty of estimating this critical parameter implies that the results should only be regarded as suggestive. Moreover, the methodology only seeks to estimate credit risk and not interest rate risk or exchange rate risk, nor does it fully take into account the indirect effects of interest rates and exchange rates on credit risk. As recent events in Argentina have demonstrated, estimating credit risk along these lines should be thought of as just one tool in attempting to assess the appropriate level of bank provi- sions and capital. Recent literature stresses the need for capital requirements and provisions to maintain a healthy financial system by limiting the risk of bank failures. In the past, the requirements reflected rules of thumb or were the outcome of complex political negotiations. More recently greater efforts have been made to quantify Veronica Balzarotti is manager of the Regulatory Policy Department with the Central Bank of Argentina. Michael Falkenheim is a financial economist with the Office of Management and Budget of the United States and a former Research Economist in the Research Department of the Central Bank of Argentina. Andrew Powell is Professor at Universidad Torcuato Di Tella and former Chief Economist at the Central Bank of Argentina. Their e-mail addresses are vbalzarotti@bcra.gov.ar, Michael_C._Falkenheim@omb.eop.gov, and apowell@utdt.edu, respectively. The authors would like to thank George McAndless and Guillermo Escudé for comments, Christian Castro and Matías Gutierrez Girault for assistance, and two anonymous refer- ees for invaluable comments. All remaining errors remain their own. The opinions expressed in this article are entirely those of the authors and do not necessarily reflect those of the Central Bank of Argentina or any other institution with which they are affiliated. © 2002 The International Bank for Reconstruction and Development / THE WORLD BANK 197 198 the world bank economic review, vol. 16, no. 2 appropriate levels of regulatory capital. The methodology usually applied is to consider what stock of capital would cover potential losses in all but a small percentage of scenarios that could prevail in the time needed to take risk- mitigating actions, such as selling risky loans or replenishing capital. The credit bureau of the Central Bank of Argentina provides a rare tool for quantifying provisions and capital requirements in this way. This credit bureau was established in 1991 to collect information on the larger debtors of the fi- nancial system and help elucidate how those debtors posed risks for the finan- cial system and for individual banks. The credit bureau has served other needs, including the need for more accu- rate information on the credit history of debtors. At an early stage the database was given to virtually all financial institutions at low cost. The power of the data to address “willingness to pay