models only had performance data for a limited population of borrowers during a property boom, when rising collateral values masked credit risk. Basel II will permit sophisticated banks in developed markets to set reserves and capital for retained mortgages using historical statistics on their expected default frequency and loss given default. But this methodology can be reasonably extended only to markets that have developed data sets that span full credit cycles.<sup>47</sup> Were the Basel II standards for internal ratings applied to subprime lending, lenders would have been required to show that they had at least five years of data on the performance of subprime loans made to target lending groups before they would receive preferential capital treatment. In contrast, the CRAs began giving triple-A ratings to pools of option ARM loans in 2000, even though there had been few such loans made to moderate income subprime borrowers. The inaccuracy of rating agency subprime default expectations only highlights the importance of moving carefully to the adoption of statistical models in markets that lack historical data.

**To the degree that Basel II raises the cost of holding risk on a bank’s balance sheet, banks will look for ways to shift risk to where it is cheaper to hold it.** U.S. and international accounting standards permitted the use of off-balance sheet treatment of large financial operations with limited transparency to investors and regulators (IMF, 2008). The use of lightly-regulated non-bank lending subsidiaries and the creation of offbalance sheet SIVs reflects relative capital and disclosure costs. Basel II addresses the use of SIVs and securitization with its Pillar 1 rules for true sale and recourse, and Pillar 3 rules for qualitative disclosure of securitization transactions.

# **5. Observations and Recommendations for Emerging Markets**

**Broadly speaking, there has been no subprime mortgage lending in emerging markets.** Instead, mortgage lending is typically made on conservative terms to middle and upper income households employed in the formal sector:

- Most emerging market households handle their economic lives in cash, lack bank accounts, and few have access to credit. Bank branches are concentrated in wealthier urban areas and their products are targeted at upper income earners. Surveys in India, Pakistan, Colombia, and Mexico show between 170 and 440 savings accounts per 1,000 people, versus between 970 and 2,400 per 1,000 people in developed countries. Loan accounts in India, Bangladesh, and Pakistan range between 30 and 80 per 1,000 people, versus between 250 and 775 in developed countries.<sup>48</sup>

- Consumer finance markets are relatively small in emerging markets. Consumers tend to carry less debt than do their developed country counterparts, and they often prepay

> 47 Or, at least five years of performance data, per Basel II. This is unlikely to span a full real estate credit cycle. For example, the subprime boom period extended from 2000 to 2006, and the bust period has just begun. After its 1980s real estate boom, the bottom of the cycle in Japan lasted more than ten years, referred to by some observers as the lost decade.

> 48 REF A2F sources, Jayamaha; Caskey, et al 2006.

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