Making Basel III work for emerging markets

Thorsten Beck, Liliana Rojas-Suarez 04 May 2019

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The 2008 crisis originated in the financial systems of advanced countries and, not surprisingly, one of the important responses to prevent another credit crunch – the Basel III international standards – focused primarily on the stability needs of these countries. A detailed and wide-ranging set of measures developed by a forum of bank regulators, representing mainly the G20 nations, Basel III aims to strengthen the regulation, supervision and risk management of large banks around the world (BCBS 2017). While it is calibrated primarily for advanced countries, many emerging market countries are in the process of adopting and adapting to these rules, and many others are considering it (Hohl et al. 2018).

A recent report from the Center for Global Development (Beck and Rojas-Suarez 2019) assesses the implications of Basel III for emerging markets and developing economies (EMDEs) and provides recommendations for both international and local policymakers to make Basel III work for these economies. It is the outcome of intensive discussions among a task force of current and former senior central bank officials from EMDEs, led by the two of us. 

Looking at Basel from the South

Our conceptual framework starts from specific characteristics of developing and emerging markets 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. 

These characteristics help explain why the impact of regulatory reforms, such as those under Basel III, is expected to be different in EMDEs than in advanced countries. They also imply the need for a differentiated approach to bank regulation to make Basel III work in these countries and lead us to the following principles underpinning our recommendations: 

  1. Minimise/reduce negative spillover effects of Basel III adoption in advanced countries, which might come through cross-border lending to EMDEs and the creation in EMDEs of uneven playing fields between affiliates of global banks and domestic banks. 
  2. Proportionality: The application of Basel standards has to be adapted to the circumstances in EMDEs to maximise the stability benefits for their financial systems. This implies both proper specification of risks and adequate calibration and adaptation of the standards to the risks without weakening the prudential and supervisory framework.  
  3. Minimise financial stability versus financial development trade-offs: While the primary objective of financial regulation is financial stability, the economic and social returns to further financial deepening are substantially higher in EMDEs than in advanced economies, calling for a balance between stability and development concerns. 

In the following, we will discuss some of the task force’s recommendations. 

Minimising potential spillovers on EMDEs

One important area of concern are the significant changes in the volume and composition of cross-border financing to EMDEs since the Global Crisis, including a reduction in cross-border lending from global banks, a heavier reliance by EMDEs on debt issues rather than cross-border lending, and an increasing role of South-South lending (Cerutti et al. 2018, Rojas-Suarez and Serena 2015). These three developments have important policy implications, but also call for more analysis. On the one hand, regulators from advanced economies may follow the US Federal Financial Institutions Examination Council’s (FFIEC) example of making bank-level data on foreign exposures public, including on loans to EMDEs to thus expand the currently extremely limited research on the effects of Basel III on cross-border lending to EMDEs. However, if these data cannot be made public, the Task Force recommends that the International Banking Research Network (IBRN), a group of researchers from over 30 (with the number growing) central banks and multilateral institutions that analyses issues pertaining to global banks, broaden and deepen their analysis on cross-border spillover effects for EMDEs.

Infrastructure finance

Emerging markets face daunting challenges in building and upgrading infrastructure in telecommunication, transportation, energy and water, which requires resources beyond those available to the public sector. There has been an increasing trend towards private participation in infrastructure funding, but many obstacles remain.   While it is far from clear that Basel III has been a primary factor behind the relative reduction in private infrastructure finance in EMDEs (FSB 2018), an ongoing challenge is that infrastructure is currently not an asset class in itself (Ketterer and Powell 2018). If projects can be developed in a more standardised fashion and there is agreement on the different dimensions of risk and how they should be quantified, then it may become easier to issue securities backed by infrastructure projects. The task force therefore supports efforts to develop infrastructure as an asset class (or a set of asset classes) and to seek standardisation in various aspects of infrastructure project development (in terms of the analysis of cash flows and risks, in the types of contracts that are used and in terms of securities issued) should therefore be pursued and intensified.

Cross-border banking in EMDEs: A level playing field?

There is also potential for spillover effects through the large presence of affiliates of global banks in EMDEs (e.g. Levin-Konigsberg et al. 2017).  Supervisors of global banks in advanced economies require that regulations, including Basel III, be applied and enforced on a consolidated basis, that is, to the entire banking group, including its foreign affiliates. But this can mean that the same sovereign exposure might get different regulatory treatment by home-country than by host-country supervisors. Currently, for example, in calculating capital requirements, most EMDE authorities assign a risk weight of zero to papers issued by their sovereign and denominated in local currency, whereas global banks largely use their own internal rating models for this purpose. Thus, it is plausible that the same sovereign paper issued by an EMDE government could be treated as a foreign currency-denominated asset, with higher risk weight requirements, if held by a local subsidiary of a global bank, and as a local currency-denominated asset if held by a domestic bank. This, in turn, increases the cost to the subsidiary to hold the sovereign paper. Given the importance of these banks in the provision of liquidity of government securities, the financing costs of EMDE governments would face upward pressure. Although this issue has not changed from Basel II to Basel III, its relevance remains high. One possible solution would be to agree on threshold values for a set of easily verifiable and widely available macrofinancial indicators (including, but not limited to, international credit ratings). For host countries whose indicators surpass the thresholds, home-country supervisors and global banks would accept, at the consolidated level, the host country’s regulatory treatment of these exposures

Aiming for proportionality

As EMDEs proceed to adopt and implement Basel III in their countries, proportionality implies adjusting capital and liquidity requirements to the capacities and needs in EMDEs. Many emerging markets ‘gold-plate’ capital requirements, increasing them beyond international standards to reflect higher risks. It might be better to use a data-driven process to determine the riskiness of assets and thus the necessary capital buffers.  Where available, micro-data can be used to calibrate risk weights to the realities and stability needs of emerging markets.  When it comes to liquidity requirements, simpler ratios might be called for if the data requirements for the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) are not easily fulfilled. On the other hand, the typical characteristics of EMDEs, as discussed above, might make a centralized, systemic liquidity management tool necessary. Specifically, banks could be mandated to maintain a fraction of the liquid assets required to fulfil Basel III requirements with a centralised custodian such as the central bank. This would aid monitoring and would allow the relevant authorities to publicize the systemwide liquidity available, thus boosting market confidence and preventing systemic problems from occurring in the first place. These liquidity requirements should be remunerated and would form part of the Basel requirements, and thus would simply be a centralised form of compliance. In highly dollarised economies, however, part of this centralised liquidity tool might have to be held in hard currency.

Not only do capital and liquidity requirements as recommended by Basel III have to be adapted to the needs and capacities of EMDEs, but they, along with a core regulatory toolbox in advanced countries, might not be sufficient to address critical stability concerns specific to many EMDEs. There might thus be a need for cruder instruments than proposed under Basel III, including lending and exposure restrictions such as already exist in some EMDEs. Such restrictions would go beyond single-exposure limits and could refer to sectoral, geographic, or foreign-currency lending exposures.

Minimising trade-offs between financial stability and development

While the financial stability goal in Basel III is necessary, policymakers must keep in mind the sometimes sharp differences between advanced economies and their emerging market counterparts. The growth benefits from deeper and more efficient financial systems are larger in emerging than in advanced markets (Ranciere et al. 2008). And when banks are – correctly – subject to increasingly tighter regulatory standards, there is a bigger premium on developing non-bank segments of the financial system, such as insurance companies, pension funds, and public capital markets – segments that are still underdeveloped in most developing economies.

Looking forward

Our report includes recommendations for regulators in advanced and emerging markets.  However, it also includes important recommendations for international institutions and fora.  One important challenge for international policy coordination is that although the Basel III framework in its current form might not be appropriate for many EMDEs, its adoption is often seen as important signal to the international investor community. It might be worthwhile considering elevating other standards to fulfil such signalling functions. For example, compliance with the Basel Core Principles of Effective Banking Supervision (BCP) is a prerequisite for effective implementation of Basel III recommendations. However, in many EMDEs, there are significant deficiencies in meeting key BCPs. Thus, the task force thinks that it is important that international financial institutions (including the Basel Committee) make explicit efforts to favour adoption of BCP as the primary signal of regulatory quality in EMDEs, thus helping to change the public perception that compliance with Basel III is the right metric to follow in EMDEs.

References

Basel Committee on Banking Supervision (BCBS) (2017), High-Level Summary of Basel III Reforms, December. 

Beck, T and L Rojas-Suarez (chairs) (2019), Making Basel III Work for Emerging Markets and Developing Economies: A CGD Task Force Report, Center for Global Development, April. 

Cerutti, E, C Kock, and S-K Pradhan (2018), “The Growing Footprint of EME Banks in the International Banking System”, BIS Quarterly Review.

Financial Stability Board (FSB) (2018), Evaluation of the Effects of Financial Regulatory Reforms on Infrastructure Finance, 20 November.

Hohl, S, M C Sison, T Stastny, and R Zamil (2018), “The Basel Framework in 100 Jurisdictions: Implementation Status and Proportionality Practices”, Financial Stability Institute Insights on Policy Implementation No. 11, Bank for International Settlements.

Ketterer, J and A Powell (2018), “Financing Infrastructure: On the Quest for an Asset Class”, IDB Discussion Paper 622, Inter-American Development Bank.

Levin-Konigsberg, G, C López, F López-Gallo, and S Martínez-Jaramillo (2017), “International Banking and Cross-Over Effects of Regulation: Lessons from Mexico”, International Journal of Central Banking 13(2): 249-271.

Ranciere, R, A Tornell, and F Westermann (2008), “Systemic Crises and Growth”, The Quarterly Journal of Economics 123(1): 359–406.

Rojas-Suarez, L, and J M Serena (2015), “Changes in Funding Patterns by Latin American Banking Systems: How Large? How Risky?”, Banco de España Working Paper 1521.

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Topics:  Development Financial regulation and banking

Tags:  BASEL III, financial stability, emerging markets, developing countries, infrastructure finance

Professor of Banking and Finance, Cass Business School; Research Fellow, CEPR

Director, Latin American Initiative, and Senior Fellow, Center for Global Development

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