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The Cost of Financial Reform for Emerging Markets

Otaviano Canuto's picture

In the aftermath of the global economic crisis, financial market regulators have proposed a myriad of reforms to better govern the banking sector and to enhance its resilience to future shocks. In fact, in September 2010, a number of measures were agreed upon by the Basel Committee on Banking Supervision, an international forum designed to foster cooperation and develop standards on banking supervisory matters. The cornerstone of these reforms—collectively known as “Basel III”—is a commitment to stronger capital and liquidity requirements, which will ensure that banks are better able to absorb losses in the future. Other significant measures include reforms to improve supervision, risk management, governance, transparency, and disclosure in the financial sector.

As I argued in a recent article, “Reviving a Policy Marriage,” such a harmonization of financial supervision and macroeconomic management can be the key to happy cyclical endings in the long-term. However, concerns have been raised that the costs of moving to higher capital ratios may lead banks to raise their interest rates and reduce lending in the short-term, which can pose financing problems for emerging markets that are dependent on global banking flows.

In the most recent edition of the World Bank’s Economic Premise series, authors Swati Ghosh, Naotaka Sugawara, and Juan Zalduendo examine the short-term impacts of the regulatory changes proposed under Basel III on emerging markets. In their note, “Bank Flows and Basel III—Determinants and Regional Differences in Emerging Markets,” the authors argue that “emerging markets are likely to be affected through both trade and financial flows.” To be more precise, the authors’ simulations show that “emerging markets will record a decline of 3 percent in banking inflows for each decline of 100 basis points in interest rate differentials.”

Such changes in financial and trade flows can have significant impacts in emerging markets where financing is less readily available. To be sure, a decrease in direct loans to emerging markets could lead to a decline in investment, economic activity, and asset prices. Accordingly, while we are moving forward with financial market regulations to ensure the stability and resilience of the banking sector in the long-term, we should remain keenly aware of the potential short-term effects in emerging markets.


I have, since 1997, strongly and publicly objected the regulations coming out of the Basel Committee, because their fundamental regulatory pillar is capital requirements based on perceived risk; as perceived by the official risk perceivers, the credit rating agencies. Not only is that outright stupid because since the credit ratings is already information used by the banks when setting their risk premiums, forcing the banks to consider them once again in their capital requirements, causes these ratings to be excessively considered... which has of course serious consequences... given their human fallibility. But also, and with respect to the emerging countries, let me ask two questions: First, where do you think the good ratings primarily reside, in the “rich” developed countries or in the emerging countries? Second, where do you think the not so good ratings primarily reside, in the “rich” developed countries or in the emerging countries? If you answer what I believe you will answer, then you will see that these capital requirements, by pushing bank lending towards what is officially perceived as “not risky” and away from what is officially perceives as “risky”, serve as capital controls which arbitrarily discriminate against the emerging countries. These capital requirements discriminate of course also against emerging small “risky” businesses and entrepreneurs in the developed countries; and to such an extent that some of these countries have already started to submerge. Compared to the silliness of having capital requirements based on perceived risk; silly as we all know that the real dangers do not lurk where risk are perceived but where they are not perceived; and though I am not really proposing it, as that could create additional confusion... would not capital requirements based on “job potential creation ratings” sound something more interesting? Frankly, it is a real shame that the whole issue of what risk-taking development requires, is so completely ignored by the world’s foremost development bank. P.S. Swati Ghosh, Naotaka Sugawara, and Juan Zalduendo write in their paper “reform proposals concerning the regulatory framework governing the banking sector—collectively referred to as “Basel III.” …are expected to generate substantial benefits by reducing the frequency and intensity of banking crises”. This is plain wrong! If you reduce the frequency of banking crisis, you can bet you will increase their intensity. And so I said over and over again while an Executive Director of the World Bank 2002-2004 at the time Basel II was being discussed. No one wanted to listen then...

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