Paper ID Number: 253
Paper prepared for the
EY International Congress on Economics I
"EUROPE AND GLOBAL ECONOMIC REBALANCING"
Ankara, October 24-25, 2013
Critical Evaluation of Basel III as Prudential Regulation and
its Consequences in Developing Countries’ Credit Needs
Sherpa, Dawa1
1 Centre for Economic Studies, Jawaharlal Nehru University, New Delhi, India
[email protected]
Copyright © 2013 by Dawa Sherpa. All rights reserved. Readers may make verbatim copies of this document for noncommercial purposes by any means, provided that this copyright notice appears on all such copies.
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
Critical evaluation of Basel III as prudential regulation and its
consequences in developing countries’ credit needs
Sherpa, Dawa
Jawaharlal Nehru University, New Delhi
Abstract
This paper seeks to critically evaluate the nature and motivation for the regulatory frame sought in
the Basel III norms and its consequences on the credit needs of developing countries. After the failure
of previous two Basel accords (I and II), to act as the effective prudential regulation of large financial
institutions operating on global scale, the new Basel III accord is hailed as the new regulatory rule
which has successfully taken into consideration of all the lacunas of earlier accord. But structurally
all Basel accords are market mediated regulation, which tries to contain systemic crisis of financial
institution by imposing better liquidity and capital requirements on financial institutions. It was
unable to deal with strong elements of regulatory capture, which virtually makes it ineffective. All
Basel accords at best tries to stop bank insolvency issues during crisis period but it does not prevent
the crisis from occurring altogether (like Glass Steagall act, at 1933 in US). Not only it is micro
prudential in nature, it also ignores endogenous evolution of risk of underlying assets of financial
institutions. Also non-binding character and ‘one size fit for all’ approach of the recommendation
makes it very hard to implement. And for developing nations new Basel III has the potential to make
flow of credit more volatile and pro-cyclical and additionally it raises the cost of financing and
reduces the level of credit available for developmental purposes. It is unable to deal with the issue of
regulatory arbitrage and consequent rise of shadow banking activities in developing countries which
are raising serious concern of systemic risk in financial system of these countries.
Keywords: Basel III, Macro Prudential Regulation, Shadow Banking, Structural Regulation
JEL classification: JEL:G1,JEL:G2,JEL:F
1. INTRODUCTION
Finance in general and banking in particular plays very important role in any healthy
economy. Besides serving as payment and settlement systems it also channelizes credit to different
sectors of economy. It facilitates transaction across time and mobilises saving from different
depositors and provides fund for different investment projects of different time lags. In process of
credit intermediation it pools risks in behalf of multiple savers. Primary source of banks’ income is
the interest rate spread net of all cost of running a bank. If banks are not properly regulated on their
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
scope and nature of activities then the inherent tendencies to make more profit (income) will direct
them to high risk- high return (speculative) activities. Besides usual liquidity-maturity mismatch
problem which they face, banks in lieu of making higher profit will take excessive risks. They may
fuel asset price bubble and when this bubble bursts it will generates shock in banking system. So any
shock (endogenous or exogenous) in banking system virtually freezes the entire economy. The
process of credit intermediation gets disrupted and squeezes the pipeline of credit to different sectors
reducing potential growth rate of entire economy. This kind of shock can get converted to rapid global
contagions in a world of large and complex financial giants interconnected across nations with
recessionary impact on different economies. E.g. Subprime crisis of US in 2008. Hence, to reduce
shocks in banking sector, proper regulation and supervision both at national and international level is
not only desirable but most of the time indispensable.
Under backdrop of oil price crisis of 1970’s and response to systemic implication of the
failure of banks observed in Germany in 1974 and to create level playing field for banks engaged in
international operations, governors of central bank of group of developed nation called G10 1
established a committee of banking supervisory authorities popularly known as Basel Committee on
Banking Supervision (BCBS). Since committee does not possess any formal supra national
supervisory authority its recommendation (regulation) is not legally binding and relies on voluntary
compliance by the nation. Individual authorities can implement it in the way that is best suited to their
own national banking systems.
2. NATURE OF AND MOTIVATION FOR REGULATORY FRAME SOUGHT UNDER
BASEL I, II AND III
The Basel Committee was formed by G10 countries to set up international standards for
banking supervision with especially focus on capital adequacy requirements of banks to contain bank
failures and eliminate any opportunity of regulatory arbitrage primarily arising at international level.
To prevent banking crisis of 1970’s and to reduce any scope for regulatory arbitrage arising out of
weak national regulation and the “regulatory race to bottom” enjoyed by international active banks,
Basel I was created. Basel I introduced a capital measurement system and tried to harmonise
regulatory and capital adequacy standards among member nations. Under Basel I assets of banks were
divided into five different categories and for each category risk-weights ranging from 0% to 100%
was assigned. The risk-weighted assets were calculated by multiplying the sum of the assets in each
category by these risk-weights. And Banks were required to maintain at a minimum ratio of 8% of
capital to risk-weighted assets (CRWA). By imposing 8% of CRWA, it tried to address capital risk
arising at level of individual banks. Risk assessment method of bank’s asset was crude and
recognition of differential nature of banks (objectives) in different scenarios was not taken adequately
while formulating risk estimation methods. Critiques also pointed out that there was need to
incorporate market based discipline in the regulatory framework.
1
Member countries of G-10 now includes Belgium, Canada, France, Germany, Italy, Japan, Luxembourg,
Netherlands, Spain, Sweden, Switzerland, United Kingdom and the United States of America.
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
To overcome problems related to Basel I, in June 1999, the Basel Committee issued a
proposal for a revised Capital Adequacy Framework (Basel II). Basel II expanded Basel I’s capital
requirement rules and introduced internal risk assessment processes. It introduced several new factors
such as market and operational risk, market-based discipline in new regulatory framework. Under
Basel II Banks were required to keep adequate capital depending on their exposure of risky banking
activities. Acharya(2012) points out that, “In terms of risk analysis Basel II was much more
sophisticated and refined in the sense that it provided scope for adding further layer of risk categories
of bank asset, allowed for internal, and more sophisticated, risk models, and incorporated value-at-risk
based capital charges for trading books.”
The proposed new capital framework (Basel II) consisted of three pillars2:
i.
ii.
iii.
“Minimum capital requirements, which seek to refine the standardised rules set forth
in the 1988 Accord;
Supervisory review of an institution's internal assessment process and capital
adequacy; and
Effective use of disclosure to strengthen market discipline as a complement to
supervisory efforts.”
Both Basel I and II are based on micro prudential regulatory framework. Focus was on
regulation of risk emerging at individual banks but there no was no provision on regulation of risk
arising at the banking system as a whole. All specific regulatory requirements in terms of capital
requirement and risk assessment of assets categories depended on this outlook.
According to Acharya (2012), large and complex financial institutions (LCFIs) like banks that
are too big to fail, were able to effectively evade these regulatory restrictions. Using their too-big-tofail funding advantage, internal rating based (IRB) approach to calculate risk, minimising value at
risk, benefiting from the conflict of interests of rating agencies these LCFIs were practically out of
regulatory chains of Basel II. Since, the Basel II approach was primarily micro prudential in nature
i.e. concerned with risk of individual bank rather than systemic risk, LCFI were allowed to be heavily
leveraged. In addition to this it was not able to address the fragility emerging from uninsured
wholesale deposit funding on the bank liability side. So when housing market price collapsed in 2008,
entire banking system of US was in deep trouble with its consequent negative global impacts.
To close the loopholes in the regulation which the financial crisis of 2008 exposed, the new
comprehensive measures of banking sector regulation were proposed by G20 at their 2009 Pittsburgh
summit. This new comprehensive set of regularity standard for banks has been referred to as “Basel
III”.
2
Source: BIS website
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
New measures (Basel III)3 aim to:
i.
ii.
iii.
iv.
Make banking sector more robust from financial and economic stress.
Close loopholes of faulty risk management practices .More emphasis given to sound
risk managements and governance.
More emphasis was given to increase stringent disclosures norms.
Tried to overcome micro prudential nature of earlier Basel accord by introducing the
notion of macro prudential regulation. Macro prudential regulation regulates system
wide risks that can accumulate across the banking sector and as well as the pro
cyclical amplification of these risks over time.
Besides new capital adequacy issue Basil III also highlights issue of liquidity risks. One
fundamental change which Basel III brought was the recognition that a micro prudential approach to
capital requirements needed to be complemented with macro prudential regulations 4. Also quality and
quantity of regulatory capital has been increased.
Under Basel III banks are required to hold 4.5% of common equity and 6% of Tier I capital of
risk-weighted assets (RWA). Two additional capital buffers in form of (i) a mandatory capital
conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer of 2.5% of capital during
periods of high credit growth, was introduced. To contain systemic risk arising out of excessive
leverage and liquidity crunch in the system a minimum leverage ratio and two required liquidity ratios
was introduced. The leverage ratio is defined by dividing Tier 1 capital by the bank's average total
consolidated assets; the banks are expected to maintain the leverage ratio in excess of 3%. The
Liquidity Coverage Ratio demands a bank to hold sufficient high-quality liquid assets to meet its total
net cash outflows over 30 days. Whereas the Net Stable Funding Ratio requires banks to keep stable
source of funding to meet funding requirement over a one-year period of extended stress.
3. ADEQUACY OF BASEL FOR REALISING GOALS OF PRUDENTIAL REGULATION:
Acharya (2012) has rightly pointed out that all Basel frameworks (I, II and III) suffer from
fundamental conceptual inadequacy as a macro prudential regulation of banking sector for containing
systemic risk. The most important drawbacks under Basel III as prudential regulation provided by
Acharya (2012) are as following:
i.
3
Micro theoretic solution to problems arising at Macro level: Most of Basel accord
was Micro prudential in nature trying to deal with problem which was primarily
macro phenomena i.e. Systemic Risk. Though there was shift to macro prudential
Source: BIS website
Macro prudential regulation seeks to address problem emerging at macro level of banking sector as whole
(feedback effect and externalities) apparently not recognisable at micro level of individual bank. Both Basel I
and II were primarily micro prudential regulatory framework where focus was to regulate and supervise capital
risks arising at individual bank level not banking system as whole. After financial crisis of 2008 Basel III was
recognised the importance of macro prudential regulation in keeping baking system in check.
4
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
regulation in Basel III but at core it still addresses the risk arising at the level of
individual banks rather than systemic risk arising at banking sector as whole.
ii.
Failure to account for Feedback Effects: All Basel accord do not take into
consideration, feedback effects which are generated with continued interaction
between banks and banking system as whole. Theoretically it is permissible that the
in effort of reducing the risk of individual banks can increase the systemic risk of
banking sector as a whole. If there is limited scope for diversification then banks
cannot reduce their aggregate risk through diversification and even in this condition it
diversifies, this can generate false impression of having low risk far away from actual
risk they face. It raises the possibility that banks’ investments get more correlated in
quest of reducing their own risks. So, if any problem hits this investment, possibility
that all the banks get into trouble at the same time increases. E.g. it was more
comfortable to hold AAA rated tranches as a diversified portfolio on the housing
market rather than holding underlying mortgages on bank balance sheet from the
viewpoint of Basel regulatory capital requirement.
iii.
Static Risk weights of assets class: One more fundamental problem with Basel
requirement is its static risk-weights of asset classes and failure to incorporate
variations in relative risks of assets evolving over time. It has failed to take into
account of complex development of risks of underlying assets. It fails to anticipate
the risk of “any correlated or concentrated exposure of the financial sector to an asset
class which seems historically stable”. A highly rated residential MBS will be given
preference to other assets class by Basel requirement. This in turn will have
encouraging effect on banks to lend more in the aggregate to residential mortgages
irrespective of quality consideration of these loans. Hence it is due to static risk
weight that favours residential mortgage as an asset class, makes residential mortgage
more prone to risk, even though the residential mortgage as an asset class had
historically been stable.
iv.
Endogenous Liquidity Risk: Most financial firms are overleveraged on risk favoured
asset class in a correlated manner. So any realisation of risk of this asset class will put
these financial firms into endogenous liquidity risks. Here liquidity risk is
endogenous in a sense that it is not due to some exogenous shock to the system rather
the very working of system produces this liquidity risks. Basel requirements ignore
this problem. If every financial firm tries to remain liquid by selling its troubled
assets then it will dry up all liquidity and make market completely illiquid. As
Acharya puts in a very terse manner- “systemic risk is created, not only ex ante, but
also ex post. In this sense, Basel requirements induce pro-cyclicality over and above
the fact that risks are inherently pro-cyclical.”
v.
No Leverage Restriction: During US housing boom period, most of financial firms
were heavily leveraged on their assets and when crisis (housing market price crash)
hit them they were unable to de-leverage simultaneously as market became illiquid. It
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
further accentuated liquidity risk of these financial firms. Still in post crisis scenario,
the new Basel recommendation (Basel III) fails to regulate leverage arising at direct
firm level or asset level.
3.1 Regulatory Capture:
One of fundamental weakness of all Basel accords as a prudential regulation was the
influences of private players (Big Banks) in process of formulating the regulatory norms in Basel
accords which ensured their interest were taken care of. This process of actively influencing the
regulation by the regulated agencies in their favour is popularly known as Regulatory Capture (Bo,
2006; Stigler, 1971).The element of regulatory capture was starkly visible in all Basel accords making
it virtually non binding for big banks with international presence .
According to Stephany Griffith and Jones Avinash Persaud, “good banking regulation should
have at least the following features: i. they should place additional regulatory costs and scrutiny on the
big, systemically important Banks; ii. should encourage banks with superior local information; and iii.
use measures of inherent risks that, for example, do not chase booms and busts and emphasize the
diversification and spread of risks.” But regulatory provision under Basel II was doing exactly
opposite of this. It gives the indirect hint that historically the process of framing Basle Accord was
very much influenced by the interest of large international banks.
In a similar tone, Thomas Hoenig (2013), currently a director of the US Federal Deposit
Insurance Corporation argues that an enormous proliferation of the number of risk weights in Basel II
was response to the intense pressure from economic and financial experts and many of the world's
largest banks. By using internal rating based modelling these big banks were able to avoid proposed
capital requirements.
Advancing the idea of Walter Mattli and Ngaire Woods (2009) on regulatory capture, Ranjit
Lall (2011) highlights the importance of “first mover advantage” enjoyed by influential international
banks in process of framing the international banking regulation. According to him this influence
arises from the well established close networks rather than the resource base of banks. This first
mover advantage ensures that the late comers (developing countries banks, community leaders) in rule
making process are not able to significantly change the moves introduced by them. Almost all major
proposal of Basel III was successfully diluted/ overturned by the lobbying activities of big banks over
period of time making overall system as vulnerable as before the crisis. Implicitly some form path
dependency in policy making ensures that the vested interest of big banks is not compromised.
In a similar tone CP Chandrashekher,(2011) has argued lobbying effort of big banks were
successfully in avoiding much needed structural regulation (e.g. dismantling big banks that were
considered too big to fail into smaller manageable banks and strict restriction of bank activities) of
banks and diluting the original Basel III accord prepared in response to great financial crisis of 2008.
The process of regulatory capture in Basel III was openly visible in terms of progressive dilution of
strict definition of regulatory capital (tier I and tier II), continuation of internal risk assessment for
capital requirement by bank itself, the dilution of liquidity requirement and postponement of
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
imposition of other strong macro prudential measures like net stable funding ratio, liquidity ratio,
leverage ratio. Compared to $225 billion requirement as per the original December accord, under
diluted version of Basel III, 35 largest US banks are required to raise only $115 billion in fresh equity
to meet the regulatory requirement of 8% of tier i capital to risk weighted asset(CRWA). In case of
the top 16 European banks the required capital decreases from €300 to €200 billion. (CP
Chandrashekher, 2011)
Critically evaluating the concept of regulatory capture, Young (2012) argues that mere
presence and inaction of private players (Banks) in policy formulation does not guarantee that their
interest will be dominant in the final outcome. Sometimes the final outcome of process of regulatory
deliberation may go against the interest of private players. According to him more rigorous empirical
studies which recognises the heterogeneity and conflicts among private players and full range of cases
where the influence doesn’t materialise into desired outcome for private player. Summing up neatly
Young urges scholar of international political economy (IPE) to, “approach which seeks to trace the
conditions under which private sector groups are successful in their lobbying efforts, and those in
which they are unsuccessful.”
Aaron Mayor(2012) has argued that all Basel accords in post the post Bretton Wood
regulatory era were part of new international financial architecture which basically tries reregulate
financial market -“through technocratic obfuscation and insularity from democratic political
pressure”. By including the private players (banks) in formation regulatory process, the Basel accords
is “still committed to the neoliberal notion that stability is best served by private financial institutions
managing their own risk assessments through technocratic means.” Aaron (2012) also observes that
by making process of framing regulation extremely technocratic affair and by excluding democratic
scrutiny of common people, the Basel accords fundamentally depoliticises the issue of regulation. The
choice of regulation of bank through capital devolves the regulatory power from state to private player
which erodes the capacity of state to intervene in market.
3.2 Complexity and homogeneity:
One of the problem of Basel as prudential framework is its increasing complexity. Thomas
Hoenig (2013) argues that the basic flaw of allowing large banks to use highly complex modelling
tool to estimate risk of different asset categories was continued in Basel III too. It implies that
regulatory capital increase as envisaged in Basel III can be generated by manipulating risk estimates.
Hence increase of complexity in Basel III has increased potential leverage capacity of banks and a
reduction in the "fortress capital" required for a bank's "fortress balance sheet". Suggesting tangible
ratio of tangible equity to tangible assets of banks as better and much simple measure of fragility of
banks he argues that, for ten largest banks of US the ratio reached a level of only 2.8 per cent in 2007
while its risk-based capital ratio was at far above safe level (11%) prescribed by Basel capital
framework. Historically this ratio was within range of 13% to 16 % for US banking sector. Andrew
Haldane, Executive Director, Financial Stability, Bank of England argues that increasing complexity
of Basel framework is reflected by increasing no of pages devoted in each subsequent Basel reports
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
and the proliferation of regulator . He found that simple heuristics tools like simpler measures of
capital (including only equity) or simple leverage ratio in which assets are equally weighted predict
bank failure statistically much better than complex ratio like capital ratio based on risk-weighted
assets. Performance of complex measures improves when the amount of information supporting them
is large. Arguing that, as model’s uncertainty increases with small sample, simple heuristic strategies
are then likely to outperform more complex ones. He acknowledges that many large, complex
financial firms have become too large and too complex in operation to manage. He argues that such
complexity is actually "subsidised" by the current Basel framework owing to the incentives which it
provides to complexity through its encouragement of the use of internal models.
It prescribes same set of rules for banks of different countries which are not at same level of
development. It is often argued that this homogeneous regulatory structure is put in place across
heterogeneous countries to eliminate any opportunity of regulatory arbitrage. But it fails to recognise
the diversity of financial institutions which have historically evolved in particular context and
environment. So, Anglo-Saxon banking system may be different from say, German or Japanese
banking system or from emerging economies banking system. Basel regulatory framework may be
more pro-cyclical in context of developing countries banks. Diversity was partially recognised in
Basel II which allowed multiple methods of measuring risk exposures. Similarly in Basel III they are
some space given in allowing national variation in the availability of liquid financial instruments for
controlling Liquidity Risk.
Also evasion of tight regulation using off balance sheet transaction is not properly addressed.
Basel III is not very clear about curbing off-balance sheet transactions.
By imposing same set of international banking regulatory standards, it has tendency to make
banks behave in the same way at the same time making herd phenomena more prominent and
pronounced. (Alexander, Eatwell, e t al 2007)
3.3 Implicit faith on Market mediated regulation:
Besides the minimum capital requirements and supervisory review process, Basel II and III
strongly emphasize on disclosure of information to enable the market participants to evaluate the
capital adequacy of an institution. There is implicit presumption that market discipline based on
informed decision of market participants will lead to better corporate governance. Market is supposed
to act like a disciplining devise by penalise those who manage risk badly and rewarding prudent risk
management practices. Hence there is strong emphasis on sharing of information of the bank to others
market participants like investors, analysts, customers, other banks, and rating agencies. This idea of
market mediated regulation is somewhat antithetical to any idea of prudential regulation. It misses the
fundamental nature of financial market (including banks) enmeshed with moral hazard, information
asymmetry, herding and tails risk. Even relatively better informed market participant cannot avoid
herding behaviour. It also forgets the political economy of globalised finance. The stark element of
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
regulatory capture was evident during 2008 crisis. And still having unshakable faith on market
mediated discipline (regulation) is absurd at best, schizophrenic at worst!
4. IMPACT ON DEVELOPING COUNTRIES:
Role of bank in developing countries are qualitatively different from its role in developed
counterpart. Besides serving usual banking activities, banks in developing countries also have to serve
different developmental purposes. To raise living standard of people in developing countries in
inclusive way, banks have to engage in much broader range of activities. E.g. Priority sector lending,
subsidised credit to agriculture, infrastructure, industry and providing banking facilities in backward
regions etc. Here focus in not only is efficient resource allocation but also on resource creation. The
financial structures are diverse, financial innovations limited than their developed counterpart.
4.1 Impact of Basel framework:
i.
Homogeneity: One size fit all policy does not take into account diverse
developmental needs of developing countries and consequent banks’ role in it.
Almost all Basel regulations do not properly acknowledge this heterogeneous
character of developing economies and subsequent roles of banks in it.
ii.
Risk assessment methodologies and its impact: Bone of contention Issue of risk
assessment is very serious in all Basel accords, as depending on estimated risk value
it will change amount of required regulatory capital. Internal rating based approach
used by banks and risk estimates given by independent agencies are inherently
problematic. Under IRB approach low rated borrower will have to keep high
regulatory capital whereas the high rated borrowers are only required to keep little
regulatory capital. As demonstrated by recent US financial crisis that risk estimates
arrived by using internal model of banks give very optimistic figure of risks and
hence amount of regulatory capital allocated is below actual level based on true value
of risk estimate. Since, big banks can always shop around to get good credit rating
from the credit rating agencies, the risk estimates provided by credit rating agencies is
also problematic. These agencies have vested interest to produce good rating for
complex financial products issued by these financial institutions. So when crisis hits
allocated regulatory capital is usually found too small to save bank from problem of
insolvency. Problem of using internal model gets complicated in case of developing
countries as they lack the required long term historical data to get risk estimates. In
case of Small and Medium size enterprises (SMEs) of developed countries
(particularly from Germany) they have made some flexible provision but similar
treatment for developing countries is not given. The SMEs from developing countries
which employ large section of workforce can neither afford to get rating from credit
rating agencies nor are sophisticated enough to use advanced internal modelling
methods. This will reduce they access to cheap credit from formal banks forcing them
EY International Congress on Economics I
"Europe and Global Economic Rebalancing”
October 24-25, 2013, Ankara/Turkey
either to find other costly alternative sources or reduce their business. As markets of
developed and developing countries are not correlated as much as markets among
developed countries, IRB approach “significantly overestimates the risk of
international bank lending to developing countries, primarily because it would not
appropriately reflect the clear benefits of international diversification which such
lending has in terms of reducing risk.” (Stephany Griffith-Jones, Avinash Persaud,
2008). Also suspicious treatment and attachment of high risk by international banks
to developing countries credit needs, virtually make it very costly to finance
developmental projects from international source in the developing countries. On the
other hand, any developed country could have access to the same fund at much
cheaper cost for similar kind of activities, makes it doubly unfair for developing
countries.
iii.
Credit Squeeze for developmental activities:
As both quantity and quality of capital has been raised in recent Basel III regulation
(requirement of tier I capital and other buffer capital), if it is adopted in toto in
developing countries, most banks will find very hard to sustain current level of credit
expansion due to two reasons: i. Cost of additional credit rises ii. As maintaining
additional capital in the form of buffer and counter cyclical capital will raise the cost
of bank.
It is usually found that bank hold additional capital beside minimum regulatory
capital. It implies that extra regulatory capital imposed on low category of
borrowers(e.g. usually developing countries) will force bank to set aside extra capital
inclusive of given mark up. Since, the use of economic capital is not uniform across
all major banks which are engaged with emerging and developing country borrowers,
price of loan will increase with imposing of additional regulatory capital under Basel
III. In both case chances are high that cost of loans goes up in emerging economies
leading subsequent credit squeeze.
According to Vincenzo,(2012) implementation of Basel III will put banks from
developing countries in disadvantaged positions in terms of cost of raising new
capital in underdeveloped credit market and depressing effect on trade finance.
Borrowing internationally may not be an option: local banks must compete with
heavy borrowing by advanced country banks and governments. Additional capital and
liquidity requirement in Basel III will force them to ether raise new capital or reduce
them business.
Basel III treatment of trade finance is also biased against developing countries needs
and fails to recognise its importance for growth in developing countries. As Vincenzo
aptly put it, “It will force higher margin requirements on this traditionally low-margin
and low risk business. Unless banks raise more capital, this could depress trade
finance, an important source of working capital and so of jobs.”
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"Europe and Global Economic Rebalancing”
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iv.
Intensifying (and inducing) Pro-cyclicity:
Intensifying (and inducing) Pro-cyclicity may erode the hard won initial benefits
enjoyed by developing countries and may destabilise growth trajectories required to
enhance level of development. It has potential to increase pro-cyclicity of bank
lending in two ways. First, sole focus on maintaining minimum capital requirement
irrespective of economic scenario will force banks to take adverse decision.
Especially during financial downturn when banks assets quality deteriorates banks
will be forced to reduce lending rather than raise additional capital to meet minimum
capital requirement. So, during recession, banks will lend less, just to maintain
required level of regulatory capital making recession more deep and prolonged.(
Rojas-Suarez, Liliana,2012) Second, through mechanism of endogenous liquidity
shocks pro-cyclicity will be further intensified. As most of banks are heavily
leveraged on risky underlying assets class, any shock to these assets will
endogenously create liquidity freeze in the system.(Acharya,2012) This will have
more damaging effect on emerging economies as they are already suffering from
chronic problem of underdevelopment like low per capita income, massive
unemployment and poverty, malnutrition. It may destabilise the developmental
trajectories required to take off and reach the maturity stage.
5. RISK OF SHADOW BANKING IN DEVELOPING COUNTRIES: CAN BASEL III SOLVE
IT?
5.1. Definition and features of shadow banks:
According to Financial Stability Board, shadow banking can be defined as “A system of
credit intermediation that involves entities and activities outside the regular banking system, and
raises systemic risk concerns and regulatory arbitrage concerns” (FSB, 2011). This definition
highlights some important features of shadow banks like credit intermediation outside tightly
regulated banking system (which can raise systemic risk for entire financial system) and the
regulatory arbitrage concern (which is very prevalent in case of shadow banks since most of its
activities arise to overcome strict regulatory code of formal banking system). Not only that these
institutions rely on very unstable source of funding, they also do not have protection of lender of last
resort facilities and the deposit insurance.( UNCTAD's Trade and Development Report 2011; Adrian
and Ashcraft ,FRBNY, 2010). They are highly interconnected and interdependent within them self
and other financial institutions making them very complex entity (FSB,2012). This fact makes them
very difficult to regulate. Since, they are very lightly regulated they are usually found highly
leveraged (Anand Sinha 2013). They borrow short and lend long creating potential for liquidity risk
mismatch (Acharya et al 2012). Examples of shadow banks include finance companies, asset-backed
EY International Congress on Economics I
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commercial paper conduits, limited-purpose finance companies, structured investment vehicles, credit
hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.
According to Anand Sinha (2013), the shadow banking can create systemic crisis by increasing the
liquidity risk mismatch in the system, by rapid deleveraging and by spreading contagion during time
of loss of confidence and high uncertainty.
1.3 Basel III and Shadow Banking: Putting Fuel on Burning Fire
Imposition of Basel III as a prudential regulation norm will not solve the problem of shadow
banking but rather perpetuates it. Due to stringent regulatory requirement on formal banking sector
under Basel III, the incentive and scope for regulatory arbitrage will increase.
Reduction in Bank Lending and increasing the size of Shadow Banks :
Both quantity and quality of capital has been raised in recent Basel III regulation, if it is
adopted in totality in developing countries, most banks will be forced to reduce credit due to
following reasons: a) Raising additional tier I capital and maintaining additional capital in the form
of buffer and counter cyclical capital will reduce the availability of credit for low rated borrowers and
raise the lending cost of domestic bank. b) International banks will also lend less to developing
countries banks for the same reason. This will increase lending rates and thus lower lending volumes
in emerging nations(Perera 2012). Most importantly stringent requirement of Basel III has potential to
reduce trade finance which is most important source of working capital. (Vincenzo 2012) .The
shadow bank are emerging as alternative source of credit in emerging markets and developing
economies (EMDEs) when most of European banks are under pressure of deleveraging process
(Ghose et al 2012).This will force them to rely more on shadow banking for their credit needs.
Also stringent regulation on formal banks will give more impetus for regulatory arbitrage
which will eventually increase the size and activities of shadow banks. Already the policy of extra
surcharge for globally systemically important financial institution (GSFIs) was been shifted to pillar II
in Basel III making in non binding in character.
The small amount of surcharge will not discourage these giant financial institutions from
taking excessive risks because they are aware that they will not be allowed to close/fail by the
government due to it systemic importance on financial market. (Francis,2013)
5.4 Shadow Banks in Developing Countries: Case study of India and China
For most of emerging markets and developing economies (EMDEs) the size of shadow banks
are not greater than 39 % of total financial system. Financial system is dominated by banks.
Compared to developed countries shadow banks, the credit intermediation chain the shadow banks of
EMDEs is not very opaque, long and complex. (Ghose et al 2012).
Especially among EMDEs, India and China are in focus of international media for recent
rapid rise of the shadow banking activities in these jurisdictions. Sheer size and the growth of shadow
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banking in both India and China are posing serious challenge for the regulators. Due to its
interdependent, interconnected and systemically important nature, shadow banks in both jurisdictions
are now closely watched by the regulators.
According to Financial Stability Report,(2011 & 2012) the banks share of total assets of
China varies from 65% to 70% as compared to 56 % to 62% of India. The share of total assets by
OFIs are higher in India than China during the period 2002 to 2011, indicating that the proportion of
shadow banks is much higher and as such the economy is more prone to runs.
Chart 1: Average annual growth of OFI sector pre- and post-crisis (FSB report, 2012)
120
%
100
80
2002-07
60
2007-11
40
20
0
INDIA
CHINA
Source: FSB Report, 2012
Chart 1 highlights the fact that in post crisis scenario India’s shadow financial institutions are
growing much faster than China. It indicates that regulators on India should be more concerned over
rapidly growing shadow financial institution in India. For China even at low growth rate 4% per
annum sheer size China shadow bank and the rising number of recent failure of many shadow
institutions and asset bubble (like real estate bubble crash) is major concern for policy makers.
In post crisis scenario in China the massive credit growth has acted as the prime stimulus to
the growth. This growth in credit has primarily channelled through shadow banks which are
increasing fragility in the financial system. (Hsu, Sara, Jianjun Li & Yanzhi Qin,2013, Zou, X. P., Pang, Y. X., &
Zhu, H. L. 2012). The adoption of Basel III has potential to reduce credit available to small and medium
sector enterprise (SMEs) which will fuel the growth of shadow banking activities. Also the incentive
for regulatory arbitrage will increase activities of shadow banks. The Chinese economy has to bear the
burden of slow growth as the prime stimulus to growth (massive credit growth) will falter when Basel
III will come into effect.
In case of India, which is experiencing slowdown in growth of economy, raising additional
capital under Basel III will cost around Rs 7 trillion (Rs.3.2 trillion for non equity and Rs1.75 for
equity capital). Estimates are market can supply Rs. 700 to Rs.1 billion. If government wants to
maintain its current shareholding position (70%) then it needs to raise additional Rs.900 billion for
recapitalization over period of five years. Given rising level of domestic and external debt and the
slowly growing economy, it seems very implausible. Only option left will be to reduce its
shareholding to 51% and reduce cost of recapitalisation by Rs.200 billion.(D Subbarao, RBI,
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2012).The studies show that return to asset (ROA) may decline substantially forcing bank to increase
lending rates or rationalise cost structure. Implementation of Basel III will depress the return on
equity (ROE) for banks by 200-300 basis point for Public Sector Units (PSU) banks and 100 basis
point for Private banks. Due to economic slowdown, banks are already having problem of Non
Performing Asset (NPAs) (M .Jain, 2013).
In the backdrop two decades of neo liberal policies, the progressive dismantling of
development investment banks has created huge demand for safe financing of large infrastructural
projects. Due to lumpy investment requirement, long gestation period and the illiquid nature of these
infrastructural projects most commercial banks, whose depositor have high liquids-low risk
preference, shy away from giving loans to this sector. This danger of liquidity-risk mismatch was the
prime rationale for financing these projects by development banks, instead of commercial banks,
whose liabilities primarily consist of budgetary resource provided by government rather than small
depositors. The deliberate exposure of PSU banks by government in public private partnership
projects consisting of risky infrastructure sector like power generation, roads, aviation and the failure
of some of these projects has created problem of liquidity–risk mismatch forcing banks to restructure
these troubled loans from time to time. Whereas the ratio of Gross Non performing asset to
infrastructural loans has increased marginally from 0.61 per cent to 1.45 per cent between March 2009
and March 2013, the ratio of combined figure of gross NPAs and restructured advances to
infrastructural loans has risen from 4.66 per cent to 17.43 per cent. The seriousness of this problem is
highlighted by the fact that these restructured advances are slowly turning into NPAs over period of
time (Jayati & Chandrasekhar, 2013). This structural problem of banking sector which is the
reflection of unsustainablity of private debt financed consumption and investment as long term
stimulus to growth, cannot be solved through better measure of banking regulation like Basel III.
6. BEYOND BASIL III: THE WAY FORWARD
In order to pursue development objectives of enhancing employment, reducing poverty and
inequality through stable growth of economy, developing countries has to safe guard their financial
sector from the vulnerabilities and contagions arising from within and the outside the national
jurisdictions. The developing countries have to adopt structural form of regulation putting
strict restriction on activities/exposures of commercial banks. The regulatory wall between
usual commercial banks and investment banks has to be strengthening. This measure will
hinder the rapid growth of exotic financial innovation which increasing the systemic risks.
Hence structural regulation of financial system will reduce the fragility of system making it
more robust and stable. To reduce the level of interconnection and interdependence, through
which global financial contagion spreads, with foreign financial services, the developing
countries should also have restriction on entry of foreign financial services in their
economies. This will ensure that financial contagions arising in weakly regulated
jurisdiction will not cripple domestic economy.(Francis, 2013). Under the hegemony of
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global finance, the developing counties find it very difficult to pursue independent national
development (expansionary fiscal stimulus, large scale employment generation programme
etc) policies. Hence developing countries have to put some restriction on free flow of
capital,(like some form of capital control or say Tobin tax), in order to pursue their
development programmes without any major hiccups.( Patnaik, 2007,2008) To curb the
excess growth of shadow banks, which are more prone to runs and shocks, regulators has to
extend regulatory regime to shadow banks also. Relying on Basel III , which will reduce
availability of developmental credit without reducing financial fragility of system, to pursue
these development objectives will be only self defeating strategy.
7. CONCLUSION:
From point of view of containing systemic risks Basel framework is still not adequate enough.
Still it tries to address individual bank level risks but fails to address issue of systemic risk
comprehensively. Though in its recent avatar i.e. Basel III ,it has increased the quality and quantity of
tier I capital and there is provision of countercyclical buffer capitals, still implicit assumption that
market discipline devise will work in curtailing bank from engaging in any excessively risky
activities, is major theoretical drawback of this regulatory framework. Issue of measuring risk capital
of banks through internal modelling and its implication is also not properly resolved. It ignores
endogenous or dynamic evolution of risk of the underlying asset and endogenous liquidity risk
associated with such overleveraged risky asset. All Basel committee at best tries to stop bank
insolvency issue during crisis period but it does not prevent the crisis from occurring altogether (like
Glass Steagall Act,1933 of US). Also non binding character and one size for all approach of Basel
recommendation makes it very hard to implement. The issue of regulatory capture is starkly visible in
all Basel accords. Even under Basel III the progressive dilution of regulatory norms has ensured that
the interest of Multinational banks is not compromised. Though addressed partially in Basel III
framework, the Basel framework intensifies the pro-cyclic nature of bank lending. Due to lack of
historical data and inadequate development of stock markets in most of developing countries it
becomes very hard to get any sensible measure of risk using sophisticated models used for risk
calculation in developed counterparts. And for developing nations Basel has potential to make flow of
credit more volatile and pro-cyclical and additionally it raises the cost of financing and reduces the
level of credit available for developmental purposes. Developing countries should rather focus on
imposing some form of restriction on free flow of global finance in order to pursue their development
objectives and should rather adopt more robust form of structural regulation of financial activities to
contain systemic financial crisis.
.
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ACKNOWLEDGEMENT:
I would like to thank Prof. Jayati Ghosh and Prof. CP Chandrasekhar, for their guidance and valuable suggestions. I also like
to thank my friends- Marina Rai, Prawesh Singh, Harish Dahiya, Barun Adhikary, Zigme Wangde Sherpa for their
encouragement and support. However, I am solely responsible for any errors and opinions expressed in this paper.
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