Basel 2: Developing countries and portfolio diversification

The proposed new Basel Capital Accord aims to better align regulatory capital with the risk that banks actually take on. This paper argues that current proposals will inappropriately and significantly increase the cost or reduce the quantity of bank lending to developing countries, as they will make the requirements for lending to them far more stringent. The failure of the Basel proposals to take account of the benefits of international diversification implies that risk is overestimated at the portfolio level. We show that, for a number of variables (such as bank profitability) and for a number of periods, the degree of correlation between developed economies is greater than that between developed and developing countries. We also show via simulations that a portfolio diversified across developed and developing economies has a lower level of risk than one focused only on developed ones. We therefore urge the Basel committee to explicitly incorporate the clear benefits of international diversification.