BASEL III IS BAD NEWS FOR EMERGING ECONOMIES / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Basel III is bad news for emerging economies


By Michael Taylor

Published: October 14 2010 22:51

When the Basel committee on banking supervision opened its membership to larger emerging markets in 2008 it was meant to produce globally relevant standards governing the financial soundness of banks. But as Basel III staggers towards the finishing line at November’s Group of 20 leading economies meeting in Seoul, it has become clear that the needs of emerging markets have been ignored. 2004’s Basel II proved fiendishly difficult to apply in conditions where even large corporations lack credit ratings; where the data to build credit scoring systems barely exists; and where there are few institutional investors who might actually read public disclosures. Far from fixing this, Basel III makes it even worse.


Much of the agreement, of course, is aimed at advanced economy banks. Rules for their investment portfolios are irrelevant to banks that stick just to deposits and loans. Even redefinitions of capital will have little impact. Emerging market bank capital often comprises equity, reserves and not much else, while tier 1 capital ratios are already high. Bans on financial instruments might dissuade investment bankers from peddling them in emerging markets but little else.


That said, formidable technical challenges will make it hard to implement those areas where the reforms are relevant and badly needed. Basel has previously neglected the issue of liquidity, but its proposals involve sophisticated new stress testing that goes far beyond the risk management capabilities of most emerging market banks. Risk management systems also require regulators who can use judgment and discretion. But exercising discretion in turn requires things not so readily available to emerging market regulators: independence, immunity from law suits and willingness to challenge the well connected.


Even when these difficulties are put aside, Basel III poses two fundamental challenges for emerging markets. The first concerns deadlines. After the banking industry stoked fears that Basel III’s requirement to raise more capital could choke off nascent economic recovery, an Augustinian compromise was reached: “Lord, make my banks well capitalised but not yet.” As a result, implementation is now stretched until the end of this decade.


Yet emerging markets need to operate on a different timetable. They have rebounded from last year’s global recession and, in some cases, are experiencing booms that monetary policy, still effectively set in Washington DC, is not constraining. Increasing capital and liquidity standards now, under the cover of international requirements, would have had beneficial counter-cyclical effects. However, Basel III’s transition period means that no emerging economy is likely to want to be the first mover. Bankers in developing countries will argue with some justification that they should not be disadvantaged relative to competitors in advanced economies.


The second challenge is whether it makes sense for emerging market banks to be more highly capitalised and liquid than those in wealthier countries. In the past it was an article of faith that emerging market banks needed bigger capital and liquidity buffers, because of their more volatile operating environment. But, as the tier 1 ratio rises, should emerging economies ratchet up their own requirements just to maintain an emerging market premium?


The question matters because emerging and advanced economies have different risk appetites. For the latter, the goal is to avoid a repeat of the crisis. By contrast, for emerging markets the objective is growth to meet the needs of rapidly expanding populations. Another turn to the regulatory ratchet would make their banks stronger and more stable, but at the risk of lowering growth.


In short, the Basel committee needs to offer an alternative standard tailored to the needs of emerging markets. The elements of such a “Basel III-lite” are not hard to find: a simpler measure of a bank’s leverage based on a ratio of total assets relative to core capital; rules to ensure that risks cannot be hidden off balance sheet or in subsidiaries; simpler liquidity rules; and clear guidelines to ensure that bad loans are promptly written down in value. Even better, it might be possible to implement such a plan more quickly than the decade we must wait for full compliance with Basel III.


The writer is an adviser to the Central Bank of Bahrain. He writes here in a personal capacity. An extended version will appear in the IFS school of finance’s Financial World magazine


Copyright The Financial Times Limited 2010.