The 2008 crisis originated in the financial systems of advanced economies, and now policymakers should ensure one of the flagship measures intended to prevent another credit crunch – the Basel III international standards – can be adapted by emerging economies and their financial institutions without unintended, and potentially harmful, consequences.
The need to be cognizant of regional differences when crafting and implementing global financial stability is necessary, when you factor in the different situations regulators face on the ground.
Research published last month by economists at the International Monetary Fund found that in advanced economies, loan-to-value limits (restricting how much financial institutions are allowed to lend against the value of the asset, such as a home) is the most popular macro-prudential tool. In emerging market and developing economies, however, limits on foreign exchange positions (the difference between the bank’s assets and liabilities in a foreign currency) are the tools most widely used.
The IMF economists say this may reflect the differences in key risks, as regulators in advanced economies tend to be more worried about weaknesses in the housing market, while their counterparts in emerging and developing countries are more concerned about external shocks, including volatile capital flows and the potential systemic risks sparked by sharp fluctuations in the exchange rate.
While Basel III is calibrated primarily for advanced countries, a desire to appear less risky and attract capital means many emerging market countries are in the process of adopting and adapting to these rules, and many others are considering it.
It is the view of a task force convened by the Center for Global Development – including current and former senior officials from central banks – that three main principles should underline this process: (1) Any adoption of Basel III should be proportional to the capacity and needs of a developing country’s financial system and therefore tailored to the specific characteristics of these economies. (2) As Basel III is implemented across the globe by regulators, great care should be taken to minimize negative spillover effects in terms of credit availability for developing countries. (3) Regulations should not result in a zero-sum game between financial development and financial stability.
More stringent capital requirements are said to be one of the factors pushing global banks to consolidate, exiting many African countries to reduce their geographical footprint and cut costs.
Furthermore, the CGD paper argues that tighter capital rules contained in Basel III may have played a role in global banks scaling back lending activities that are essential to economic growth – such as funding infrastructure projects or providing trade finance.
The effect of Basel III on bank-based infrastructure finance is a particular concern in many emerging economies given the limited sources of alternative, market–based funding available. Under Basel III, banks could be forced to hold significantly more capital to cover loans considered very risky, making infrastructure funding more expensive and unattractive. In addition, new liquidity requirements mandate that loans with a maturity over one year have to be matched with funding of a similar duration, pushing banks to match infrastructure loans with longer-term funding, which might increase (possibly to prohibitive levels) the cost of infrastructure funding.
Trade is a major component of the global nervous system, pulling many populations out of poverty and into the middle class by spurring economic growth, creating jobs and fostering stability. Basel III could also significantly undermine cross-border trade financing by forcing banks to hold more capital to cover the loans. Provisions such as the leverage rule, risk weighting requirements and liquidity rules will make it an even more expensive endeavor and compound what is already a low-margin business.
To avoid a blanket approach to enforcing the Basel framework, the CGD says additional conditions should be identified that emerging and developing economies can meet to reassure the home-country regulators of global banks. These could be a set of easily verifiable and widely available indicators such as international credit ratings. It would solve roadblocks such as a home-country regulator assigning a higher risk designation to a global bank subsidiary’s holdings of local currency-denominated sovereign debt.
Developing countries and emerging market economies adopt Basel III because they see it as in their long-term interest, but the one-size-fits-all approach of the new standards poses new risks and challenges. It is the same reason multilateral development and lending institutions need to embrace a more distinctive and tailored approach to financing development in low-income countries.
Basel III does not take into consideration certain characteristics of developing and emerging market countries that, while not universal, are common enough to not be disregarded: variable access conditions to international capital markets; high macroeconomic and financial volatility; less developed domestic financial markets; limited transparency and data availability; and capacity, institutional, and governance challenges.
The complexity of Basel III underscores the need to step back from a wholesale application of the rules. The CGD urges regulators in developing and emerging market economies to prioritize the key risks in their banking sectors, and match their supervisory efforts accordingly to ensure a more proportional application of the regulations.
And finally, the task force says it is critical that a cost-benefit analysis occurs before the introduction of any new financial regulatory standards, assessing the potential benefits of higher stability against the costs for local regulators, the institutions they oversee, and – most importantly – the economy. To ensure a smooth transition to the new standards, regulators should announce the changes early and allow for long implementation periods, including a gradual introduction of tighter capital or liquidity requirements.
While the financial stability goal in Basel III is necessary, policymakers must keep in mind the, sometimes, sharp differences between advances economies and their emerging market counterparts. The increased costs from higher capital and liquidity standards in Basel III could be a disincentive to investment in countries viewed as riskier than the developed markets.
A desire to prevent a repeat of 2008 should not distract from the unintended consequences that would be a brake on the important process of evolution and innovation in emerging markets.