White Papers for Basel II Capital Accord (Basel II)

How will Basel II affect bank lending to emerging markets An analysis based on German bank level data

The new Basel Accord on capital requirements for banks (Basel II) defines regulatory
capital requirements in line with the underlying risk of lending and therefore marks a
substantial modification from previous regulation. This will raise regulatory capital
requirements for higher risk asset classes, which include the emerging markets. Higher
regulatory capital has an impact on lending flows only if regulatory capital requirements
become binding. In other words, if banks have already calculated economic capital based
on similar risk models in the past and these remain binding no further change should occur.
This paper tests these two interlinked hypothesis. We expect that lending patterns will
remain unchanged if:
(1) regulatory capital requirements remain below the economic capital and
(2) banks’ lending is already based on risk modelling.
To test the first hypothesis we calculate the economic capital of the foreign portfolio of
German banks as unexpected loss using a Value at Risk model. We find that economic
capital seems to be binding.
The second condition is tested by estimating the influence of unexpected loss in explaining
lending to emerging markets. We find that unexpected loss is a significant determinant of
the banks’ loan decisions, in particular for Large Banks as well as Landesbanken and in
recent years also for other banking groups. Thus, it appears that risk modelling has already
guided lending decisions.
Overall, the evidence from both tests points in the same direction and we conclude that the
new Basel Accord should have a limited effect on lending to emerging markets.

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