Basel III & Unintended Consequences for Emerging Markets and Developing Economies - Part 1: Cross-border Spillover Effects

Basel III is the most extensive, post-global crisis financial regulatory standard to date, but it is rarely discussed by development economists. In fact, debates and discussions on Basel III are largely confined to financial circles (from both the private and public sectors) and mostly in advanced economies.

This is a major oversight.

Initially designed for internationally-active banks, Basel III recommendations are expected to be adopted globally. They include capital and liquidity requirements, limits on leverage and specific regulatory treatment for banks that are deemed “too big to fail.” Basel III is critical in minimizing the risk of systemic fragility and banking crises, while allowing financial systems to support the real economy. The recommendations will have a substantial impact on banks’ capacity and incentives to channel foreign and domestic savings which could have major implications for economic development and poverty reduction.

However, questions remain as to whether some of the proposed Basel III recommendations might generate unintended consequences for financial deepening and financing of economic growth and development or even for achieving the desired goal of reducing financial fragility in emerging markets and development economies (EMDEs). As co-chair of a CGD Task Force exploring these questions, I will be publishing a series of blogs on the group’s analysis.

This first blog addresses the unintended, spillover effects of Basel III on the volume, composition, and stability of cross-border flows to EMDEs arising from the adoption of Basel III in advanced economies. Tapping these inflows is vital for development because of low domestic saving rates and under-developed capital markets in many EMDEs.

After reaching a peak in 2007, Chart 1 shows a declining trend in cross-border bank loans to EMDEs, albeit with significant volatility. This reduction is mostly attributable to banks from the US, UK, and the Eurozone. Why have these flows remained so low? There are many factors driving the decline including the deleveraging and quantitative easing processes following the global financial crisis, the increased enforcement of anti-money laundering and countering the financing of terrorism (AML/CFT) standards, and competition from the non-bank sector.

Chart 1: Cross Border Bank Lending to EMDEs (USD billions)

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The tightening of regulations governing the activities of banks, most notably through Basel III (and the Dodd-Frank Act in the US) is only one factor in the cross-border decline. But it seems to be important. The lending behavior of US banks in the post-Dodd-Frank era can provide some insights.

Since US banks’ deleveraging process to resolve financial difficulties has been practically completed, total US bank lending has been recovering since 2014. Moreover, US banks’ cross-border lending to advanced economies has also been on a rising trend in recent years.  However, as shown in Chart 2, US banks’ lending to EMDEs has continued to decline and remained in negative territory in 2017, a year of improved economic growth in almost all regions in EMDEs.  This signals the persistent effects of financial regulatory incentives.

Chart 2: US BIS-Reporting Banks Cross-border Lending (USD billions)

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Now, cross-border bank lending from advanced economies to EMDEs has been partially offset by the huge increase in EMDEs’ issuance of debt securities in international capital markets and the rapid increase in South-South bank lending. That is, EMDEs have (at least partially) shifted from international bank finance to capital markets finance and from borrowing from international banks from advanced economies to those from emerging market economies.

Chart 3 shows the shift in the composition of EMDEs’ external sources of finance from bank lending to issuance of debt.

Chart 3: Shifting External Sources of Funding in EMDEs (USD billions)

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In terms of South-South lending, emerging markets have been quick to capture markets exited by banks from advanced economies, with Brazil, China, India, and South Africa expanding in their respective regions.  Pan-African lending in particular has grown significantly since the global financial crisis. This recent trend reflects increased economic integration within African countries and is supporting improved competition in the banking industry.

These developments are relaxing immediate financial constraints in EMDEs and could potentially be a welcomed long-term outcome, but only if the new sources of funding prove to be sound and stable.

Are they? Unfortunately, this is not yet clear. Crucial questions remain on the nature of the alternate sources of funding. For example, a significant proportion of EMDEs’ bonds are now held by institutional investors; but it has not yet been established that the behavior of these investors is less procyclical than that of international banks. Additionally, there are deficiencies in banking regulatory and supervisory frameworks in South-South banks, especially Pan-African ones, and concerns about over-indebtedness of some developing countries stemming from the influx of Chinese loans.

What is clear is that Basel III is transforming the global financial landscape. However, designed to enhance financial stability, Basel III is having unintended consequences for financial deepening as evidenced in the reduction of cross-border lending from advanced economies to EMDEs. If development economists and policymakers want to avoid the costs of financial fragility and systemic banking crises, they need to start paying attention.

The next blog in this series will focus on Basel III’s impact on trade finance, a key financial service for development.