balance sheet netting,<sup>36</sup> Basel II netting rules apply in measuring exposures in securities financing transactions (such as repos, reverse repos, securities lending and borrowing, and margin lending transactions) and derivatives.

The calibration of the leverage ratio needs careful consideration. The Basel III Tier 1 leverage ratio of 3 percent may not be a meaningful constraint for banks in many developing countries, as they tend to have modest leverage. Some countries may choose to adopt a more prudent requirement. For example, China plans to follow the Basel III definition of Tier 1 leverage ratio, but impose a higher requirement of 4 percent. As mentioned, a different calibration may be justified due to different characteristics of the financial system in developing countries, although whether it is needed also depends on level of concerns about specific issues. Too stringent calibration may render the risk-weighted requirement ineffective and create perverse incentives.

# **3. Reducing the Cyclicality of the Minimum Capital Requirements**

Many developing countries are still under the Basel I regime, but expectations are that over time Basel II will be implemented widely around the world.<sup>37</sup> As countries make the transition to the Basel II framework, they will inevitable face the trade-off between risk sensitiveness and procyclicality, as the actual levels of minimum capital requirement vary through the cycle in response to the changing risks and tend to amplify the cycle through the availability of credit.

The degree of procyclicality depends on the extent to which banks over-rely on external credit ratings (which tend to be backward-looking and procyclical) under the standardized approach, and to which banks‘ risk management and capital planning are based on point-in-time (PIT) estimates of potential credit losses under the IRB approach, rather than through-the-cycle (TTC) estimates.<sup>38</sup> The issue is also important because the effectiveness of the countercyclical capital buffer (such as the one devised under Basel III, which will be discussed in the next section) will depend on the degree of procyclicality of the minimum capital requirement, on top of which the buffer is built.

Under the standardized approach, minimum capital requirement relies on external ratings, which tend to be backward-looking and procyclical. The issue of external ratings is many-faceted, requiring policy changes on multiple fronts. One of the measures that have been proposed in the international debate, in particular at the Financial Stability Board (FSB), is to reduce or remove

> 36 For example, currently the U.S. Generally Accepted Accounting Principles (US GAAP) allows for more netting than IFRS, resulting in the same financial institution having larger balance sheet under IFRS than under US GAAP, which has implications for the calculation of leverage ratio if left unadjusted. This is expected to be resolved in the near future, as IASB and US FSAB are jointly developing a converged standard on balance sheet netting. 37 The results of 2010 Financial Stability Institute (FSI) Survey on the Implementation of the New Capital Adequacy Framework indicate that 112 out of 133 jurisdictions that responded to the survey have implemented or are planning to implement Basel II. See FSI (2010) for more details.

> 38 Using data for Spanish banks from 1987 to 2008, Repullo, Saurina, and Trucharte (2010), for example, show capital requirements calculated using point-in-time estimates of PDs move significantly along the business cycle, ranging from 7.6 percent to 11.9 percent per unit of loan from peak to trough.

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