61405 POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise APRIL 2011 • Number 56 Bank Flows and Basel III—Determinants and Regional Differences in Emerging Markets Swati Ghosh, Naotaka Sugawara, and Juan Zalduendo The global financial crisis has led to a range of reform proposals concerning the regulatory framework governing the banking sector—collectively referred to as “Basel III.” Although the proposed reforms are expected to generate substantial benefits by reducing the frequency and intensity of banking crises, concerns have been raised that, in the short term, the costs of moving to higher capital ratios may lead banks to raise their lending rates and reduce lending. This note explores the near-term implications of Basel III capital regulations on bank flows to emerging markets, based on an analysis of the key determinants of these flows. The global financial crisis has led to a range of proposals for tions and in those emerging markets closely dependent on reforming the regulatory framework that governs the bank- global banking flows. ing sector, with a view to enhancing its resilience. Agreement Based on an analysis of the determinants of bank flows from has already been reached on some aspects of these new rules, advanced economies to emerging markets that focuses on the which are collectively referred to as “Basel III” (box 1). The nature of the financial links between these countries, this note proposed new regulations cover both microprudential or examines the impact of the regulatory changes proposed un- firm-specific measures and macroprudential measures aimed der Basel III on emerging markets. The focus is exclusively on at strengthening the resilience of the banking system as a what could be referred to as the “financial flows channel”— whole by addressing the procyclicality of banking and limit- that is, through reduced lending and changes in interest rates. ing the risks arising from the interconnectedness among fi- nancial institutions. Estimates of the Potential Short-Term Although the proposed reforms are expected to generate Impact of Basel III Vary Widely substantial benefits (namely, by reducing the frequency and intensity of banking crises), concerns have been raised that, The range of estimates of the potential short-term impacts in the short term, the costs of moving to higher capital ratios on lending rates, volumes, and economic activity among ad- may lead banks to raise their lending rates and reduce lend- vanced economies adopting Basel III is quite broad. Two ing.1 In particular, if these regulations are implemented over such estimates are those of the Macro Assessment Group a short period of time, there could be a consequent drag on (MAG) and the Institute for International Finance (IIF). the economic recovery in countries adopting these regula- Based on models covering 17 countries, the MAG report www.worldbank.org/economicpremise POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK 1 Box 1. Proposed Basel III Reforms The proposed Basel III reforms aim to strengthen micropruden- Basel III, the total common equity requirement will rise tial regulations (to help raise the resilience of individual banking to 7.0 percent. institutions) and macroprudential regulations (to address sys- • Increasing the risk coverage of the capital framework— temwide risks that can build up across the banking sector and particularly, for trading activities, securitizations, expo- the procyclical amplification of these risks over time). Although sures to off-balance-sheet vehicles, and counterparty the cornerstone of the reforms is stronger capital and liquidity re- credit exposures arising from derivatives. quirements, these are being buttressed by measures to improve • Introducing an internationally harmonized leverage ratio supervision, risk management, governance, transparency, and to serve as a backstop to the risk-based capital measure disclosure. The measures that were agreed by the Basel Commit- and to contain the buildup of excessive leverage in the tee on Banking Supervision and the governors and heads of su- system. pervision in September 2010 include the following: • Raising the standards for the supervisory review process • Strengthening the quality, consistency, and transparency (Pillar 2) and public disclosure (Pillar 3); together with of capital to ensure that banks are better able to absorb additional guidance in the areas of sound valuation prac- losses. Tier 1 capital will need to be predominately in the tices, stress testing, liquidity risk management, corporate form of common shares and retained earnings, Tier 2 cap- governance, and compensation. ital instruments will be harmonized, and Tier 3 capital will • Introducing minimum global liquidity standards, consist- be eliminated. ing of both a short-term liquidity coverage ratio and a • Raising the level of the minimum capital requirements. longer-term structural net stable funding ratio. Under the current Basel II, core and regular Tier 1 capital • Promoting the buildup of capital buffers that can be are 2.0 percent and 4.0 percent, respectively. Under drawn down in times of stress, including the capital con- Basel III, core Tier 1 capital will rise to 4.5 percent and servation buffer mentioned above and a countercyclical Tier 1 capital will rise to 6.0 percent. The phase-in period buffer to protect the banking sector from periods of exces- is as follows: core Tier 1 capital to 3.5 percent in January sive credit growth. The proposed countercyclical buffer 2013, to 4.0 percent in January 2014, and to 4.5 per- will be within a range of 0–2.5 percent of common equity cent in January 2015. The difference between the total and will be implemented according to national circum- capital requirement of 8.0 percent and the Tier 1 require- stances. ment can be met with Tier 2 capital. Also, a capital con- The committee is also working with the Financial Stability Board servation buffer of 2.5 percent on top of Tier 1 is to be in- to address risks of systemically important banks. The committee troduced to ensure that banks maintain capital that can and the governors and heads of supervision have agreed that be used to absorb losses during periods of financial and these banks should have loss-absorbing capacity beyond the economic stress. Although banks are allowed to draw on minimum standards of the Basle III framework. Going forward, the buffer during such periods, the closer their regulatory the committee will also be working on (1) a fundamental review capital ratios approach the minimum requirement, the of the trading book; (2) a review of the use and impact of external greater the constraints will be on earnings distributions. ratings in the securitization capital framework; (3) the treatment (Currently, under Basel II, there is no capital conservation of large exposures; (4) enhanced cross-border bank resolution; buffer.) The capital conservation buffer begins at 0.625 (5) a review of the core principles for banking supervision to re- percent in January 2016, rises to 1.250 percent in Jan- flect the lessons of the crisis; and (6) standards implementation uary 2017, goes to 1.875 percent in January 2018, and and stronger collaboration among bank supervisors. rises again to 2.500 percent in January 2019. Under Source: Based on BCBS 2010. finds that the median estimated increase in lending spreads percentage point increase in the target capital ratio (reflect- is roughly 15 basis points by 2015 in response to a 1 percent- ing both the increase in capital and the liquidity standards), age point increase in the target capital ratio over four years and it finds that this results in an increase in the average (MAG 2010, table 1, p. 17). The IIF report—which looks at lending spread of 132 basis points during 2011–15 (IIF the Euro Area, Japan, and the United States—assumes a 2 2010a, table 3, p. 15). 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise In part, the differences in estimates reflect differences in Table 1. Short-Term Impacts of Basel III in Advanced Economies the regulatory changes assumed: whereas the MAG study focuses largely on the impact of a higher regulatory capital Impact Impact Rangea on on ratio, the IIF study also considers redefinition effects, higher lending economic Increase Decline in trading book capital, and a (1 percentage point) counter- rates activity in rates activity cyclical buffer. In fact, some market participants expect the Study (bps) (pp) Assumptions (bps) (pp) effective increase in core Tier 1 capital requirements under MAG 15.4 –0.16, four 1 percentage 15–90 0.16– the new rules (when all the capital-related changes are taken and a half point increase in 1.80 into account, not simply those of the higher regulatory cap- years after common equity ital ratio) to be more than 2 percentage points—perhaps as implementation ratio, implement- high as 6 percentage points (IIF 2010b, p. 20). As highlighted ed over four by Slovik and Cournède (2011), the increase in capitaliza- years tion will also depend on whether banks fully maintain their IIF 132 –0.60 Package of 66–396 0.3–1.8 regulations, in- current discretionary capital buffers above the regulatory cluding a 2 minimums. percentage point The broad range of estimates also reflects different as- rise in common sumptions regarding the implementation period. This mat- equity ratio, ters because the stock costs and flow costs of increasing cap- capital redefini- ital differ. The “stock costs” of holding more equity arise tion effects, and from factors such as taxes and agency conflicts that make eq- higher liquidity uity capital more expensive, regardless of how that equity requirements comes onto the balance sheet (that is, regardless of whether Source: Authors’ compilation. the equity is accumulated through new issuances or through Note: bps = basis points; pp = percentage points. retained earnings). The “flow costs” are associated with the a. The range depends on how much capital adjustment is needed from a 1 process of reaching the new capital ratios. Many observers percentage point increase to a 6 percentage point increase. The range of have argued that the stock costs of holding more equity may both the increase in interest rates and the decline in economic activity is obtained by taking the estimated impact under each study (namely, a 1 not be very significant because, even though equity is more percentage point increase in common equity ratio) and multiplying it by 1– risky and thus costly, these risks (and costs) are likely to fall 6 percentage points. as banks deleverage.2 In contrast, the flow costs will depend in part on the length of time given for implementation. In- deed, a more gradual phase-in period can enable banks to ad- differences in assumptions and the debate on the necessary just to the new capital ratios in a least-costly manner, such effective increase in capital under the new rules. as through accumulating capital via retained earnings. Also, although the Basel Committee has stretched the implemen- Emerging Markets Are Likely to tation until 2019, there are indications that market pressures Be Affected through Both Trade and may lead banks to adopt these regulations at a faster pace. Financial Flows Channels Finally, the capital markets’ response as banks issue new equity will also matter. The IIF report assumes that the cap- Although the magnitude is subject to considerable uncer- ital markets’ response is less elastic, which leads to a higher tainty, there is agreement that there is likely to be some cost of equity. Much of this uncertainty is also subject to the short-term impact in countries adopting Basel III.3 To the ex- strength of the recovery following the global financial crisis. tent that short-term impacts materialize, emerging markets In fact, the impact from higher lending rates and lower cred- are likely to be affected through several channels, even if one it availability on economic activity is itself subject to uncer- excludes the impact from emerging markets themselves tainty. The magnitude of the latter will depend, for instance, adopting Basel III (figure 1). Two of these channels are of on the different sources of financing. In turn, in countries particular importance. The first channel, which could be re- where capital markets can provide an alternative source of ferred as the “trade flows channel,” acts through lower eco- financing, the impact is likely to be less. Moreover, the re- nomic activity in advanced economies and consequent lower sponse of monetary authorities to any regulation-induced import activity on their part. The quantitative impact of this economic slowdown (and, of course, the scope there is for channel depends on trade income elasticities. The second such a response) would also make a difference. Against this channel, which we will refer to as the “financial flows chan- background, table 1 shows the range of estimates of the im- nel,” is through higher interest rates and the decline in bank pact on lending rates and economic activity, reflecting the flows from advanced economies to emerging markets. The www.worldbank.org/economicpremise POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK 3 Figure 1. Short-Term Impact of Proposed Basel III Regulations on Emerging Markets Adoption and impact on banking systems of advanced economies Impact depends on • phase-in period • banks’ adjustment behavior • capital market response Trade Flows Channel Financial Flows Channel Higher lending rates and lower lending volumes Magnitude depends on Magnitude depends on • availability of nonbank lending • sensitivity to interest rate • credit-output elasticities differences • monetary policy response • concentration of bank lending from advanced economies • assessment of risk Lower economic activity in advanced economies Magnitude depends on • trade income elasticities Lower trade volumes Lower bank lending Direct Channel Indirect Channel Direct effect through Indirect effect through lower lending to impact on banking systems nonfinancial institutions of emerging markets Impact can be exacerbated if bank lending and collateral channels are strong— reinforcing the dynamics between the real and financial Impact on emerging-market economies sectors through lower consumption, investment, and exports Source: Authors’ illustration. quantitative impact will depend on interest rate differentials, lems in financial markets as a result of asymmetric informa- global risks, and the overall dependence on such flows, tion and the costliness of enforcing contracts. For instance, among other things. curtailment of direct loans to firms in emerging markets In turn, within the financial flows channel, there is a di- could lead to a decline in investment, economic activity, and rect lending effect (lower lending from banks in advanced asset prices. Specifically, if collateral is an important deter- economies to nonbanks in emerging markets) and an indi- minant in banks’ lending decisions (as is generally the case rect lending effect (lower lending from banks in advanced in emerging markets because of the costs of enforcing con- economies to banks in emerging markets). These effects tracts), the decline in asset prices can reduce domestic bank might reinforce each other in the presence of agency prob- lending. This also reinforces the initial decline in direct lend- 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise ing from banks in advanced economies. The impact of less Figure 2. Potential Impact of Basel III on Banking Flows to lending by banks in emerging markets will also depend on Emerging Markets the degree to which other forms of financing are or are not a. Based on average banking flows, 2006–08 available to borrowers. For instance, small and medium en- 0.4 terprises might not be able to offset the decline, given their 050 bps percent of GDP 0.3 100 bps lack of access to stock or bond markets. 200 bps 0.2 The Impact across Regions 0.1 Will Be Differentiated 0 Focusing exclusively on the financial flows channel through es ci d ie r od 10 be ica om the Pa an at ho fic s EU an rib er on O id e ia both direct and indirect lending, we simulate the likely im- Ca Am or nd th As hb ca th tin st ig pact of increases in lending rates in advanced economies of Ea ec ne EU d La e EU the kind discussed in table 1. The simulations are based on an an analysis of the determinants of bilateral banking flows from region 17 advanced to 28 emerging markets in the Bank for Interna- tional Settlements locational statistics on bilateral banking b. Based on banking flows, 2007 flows (see Ghosh, Sugawara, and Zalduendo forthcoming). 0.6 The determinants include the traditional push (global) and 050 bps pull (country-specific) factors that are typically identified as 0.5 100 bps important determinants of capital flows, as well as indicators 200 bps percent of GDP 0.4 of nonfinancial and financial links. These links include meas- 0.3 ures of financial interconnectedness between lending and borrowing countries and indicators on financial contagion. 0.2 Of course, these simulations should be viewed with cau- 0.1 tion because they assume there are no other changes. For in- stance, the implicit assumption is that the behavioral re- 0 sponses will remain as valid even after a structural change of es ci d ie r od 10 be ica om the Pa an at ho fic s EU an rib er on O id e ia the kind introduced by the new Basel III requirements. Ca Am or nd th As hb ca th tin st ig Moreover, the calculations do not control for a reassessment Ea ec ne EU d La e EU of risks in emerging market economies following the global an financial crisis. In fact, it could be argued that, on this count region alone, capital flows are likely to be much more subdued than in the precrisis period. Disregarding these caveats, we expect Source: Authors’ calculations. that emerging markets will record a decline of 3 percent in Note: bps = basis points. banking inflows for each decline of 100 basis points in inter- est rate differentials—the change of 100 basis points is in line with the MAG and IIF reports. At the level of each region, the impact will also depend Notes on individual countries’ reliance on banking flows. We choose two different scenarios: the first is relative to the av- 1. Banks can meet higher capital ratios in three ways: (1) erage inflows during 2006–08, and the second is relative to issuing new equity; (2) increasing retained earnings through the average inflows of 2007. In both cases, we assume inter- a number of measures (reducing dividend payments, en- est rate differentials declines of 50, 100, and 200 basis points. hancing operating efficiency, raising average margins be- It is not surprising that the impact varies significantly across tween borrowing and lending rates, and increasing noninter- regions, ranging from 0.25 percent of GDP among the EU10 est [fee] income); and (3) reducing their risk-weighted assets for each change of 100 basis points to negligible levels in the by lowering the size of loan portfolios, reducing or selling East Asia and Pacific and the Latin America and the nonloan assets, and shifting their balance sheet toward less Caribbean regions (figure 2).4 Thus, for some regions— risky assets. emerging Europe, in particular—the impact is not negligible, 2. In an idealized world where the conditions set out by and this would add to the likely broader reassessment of the Modigliani-Miller theorem hold, this effect is just emerging markets’ risk mentioned earlier. enough to offset the increased weight of the more expensive www.worldbank.org/economicpremise POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK 5 equity in the capital structure so that the overall cost of cap- Ghosh, S., N. Sugawara, and J. Zalduendo. Forthcoming. “Banking Flows and ital stays fixed as the bank leverage varies. Financial Crisis—Financial Interconnectedness and Basel III Effects.” Working Paper, World Bank, Washington, DC. 3. Over the medium to long term, banks would only face IIF (Institute of International Finance). 2010a. “Interim Report on the Cu- the stock costs of holding higher capital. The Bank for Inter- mulative Impact on the Global Economy of Proposed Changes in the national Settlements has also undertaken a long-term impact Banking Regulatory Framework.” Washington, DC. study in which it considers both the benefits and the costs of ———. 2010b. “The Net Cumulative Economic Impact of Banking Sector the new regulations. It thus assesses the shift from one steady Regulations: Some New Perspectives.” Washington, DC. MAG (Macro Assessment Group). 2010. “Interim Report: Assessing the state to another (with and without reforms) when the tran- Macroeconomic Impact of the Transition to Stronger Capital and Liq- sition to the higher capital standards has been achieved. The uidity Requirements.” Basel, Switzerland: Bank for International Settle- study finds that a 1 percentage point increase in the capital ments. http://www.financialstabilityboard.org/publications/r_10081 requirement translates into a 0.09 percent median loss in the 8b.pdf. level of steady-state output. But, of course, there are benefits Slovik, P., and B. Cournède. 2011. “Macroeconomic Impact of Basel III.” from holding higher capital in as much as it succeeds in low- Working Paper 844, Organisation for Economic Co-operation and De- velopment. Paris, France. DOI 10.1787/5kghwnhkkjs8-en. ering the frequency and severity of financial crises. 4. The average inflows to emerging Europe over the About the Authors 2006–08 period was about 7 percent of GDP, thus resulting in a decline of 0.28 percent of GDP for each interest rate Swati Ghosh is economic adviser in the Office of the Vice Pres- differentials decline of 100 basis points. This assumes, how- ident for the Poverty Reduction and Economic Management ever, that there are no changes in interest rates in borrowing Network, World Bank, Washington, DC. Naotaka Sugawara is countries. a consultant in the Office of the Chief Economist, Europe and Central Asia Region, World Bank. Juan Zalduendo is lead References economist in the Office of the Chief Economist, Europe and Cen- BCBS (Basel Committee on Banking Supervision). 2010. The Basel Com- tral Asia Region, World Bank. mittee’s Response to the Financial Crisis: Report to the G20. Basel, Switzer- This note is based on Ghosh, Sugawara, and Zalduendo land: Bank for International Settlements. http://www.bis.org/publ/bc (forthcoming). bs179.pdf. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. It is produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at www.worldbank.org/economicpremise.