Basel III in Developing Countries—a Difficult Relationship

By Thorsten Beck, Professor of Banking and Finance at Cass Business School;

Emily Jones, Associate Professor of Public Policy at the Blavatnik School of Government, University of Oxford; and

Peter Knaack, Senior Research Associate at the Global Economic Governance Programme, Blavatnik School of Government, University of Oxford

In the wake of the global financial crisis (GFC), significant regulatory reforms have been undertaken—most prominently, the Basel III reforms, which tighten capital requirements and introduce liquidity requirements and macro-prudential tools. These reforms were agreed upon by the 28 members of the Basel Committee on Banking Supervision (BCBS), representing major advanced and emerging economies. While in principle, only member countries are obliged to adopt and implement these standards, they are widely seen as “best-practice” regulatory standards. And while far from perfect, many observers have pointed out their positive impacts for bank stability. However, there are important externalities from regulatory decisions in advanced countries on financial stability and development in developing countries. One of these externalities is that developing countries feel obliged to adopt and implement Basel III standards, even if they do not fit their needs and circumstances. Why do they feel obliged, and how can the challenges that come with such a decision be mitigated?

Implementation of the first Basel standard is almost ubiquitous across the globe, and the newer two standards—Basel II and III—have found widespread acceptance beyond the perimeter of the Basel Committee. Data from the Financial Stability Institute (FSI) at the Bank for International Settlements (BIS) shows that 90 out of 100 surveyed non-member jurisdictions have implemented Basel II at least partially or are in the process of doing so. Moreover, 81 jurisdictions have reported that they have taken steps towards the implementation of at least one component of Basel III. However, regulators in developing countries are typically selective adopters, choosing some components of Basel standards while eschewing others. In particular, regulators are more likely to adopt the simpler Basel II standard approaches to credit, market and operational risk instead of the much-disputed advanced approaches that rely on internal risk models by banks.

Beyond aggregate numbers, there is a wide variation in adoption of Basel II/III. On the one extreme, Ethiopia has chosen to not adopt Basel II or III. The relative isolation of Ethiopia’s banking sector and lack of multinational banks gives domestic banks few competitive incentives to adopt the Basel framework. Meanwhile, Ethiopia’s government has a strong preference for political control over the financial industry as it seeks to emulate the example of East Asian “tiger” economies, for which policy-directed finance has represented a key tool in the pursuit of rapid industrialization. Thus, in the absence of strong technical, competitive or reputational incentives, Ethiopia currently has no domestic champions for Basel II/III adoption.

On the other extreme, Pakistan has a very high level of adoption of Basel II and III. In the 1990s and early 2000s, the adoption of Basel II was driven first by a policy of promoting financial services and then by banking-sector regulators. As banks have internationalised over the past decade, they have championed the implementation of Basel III. Pakistan is one of the few cases in which all three major actors in the decision process on adoption of international standards—politicians, regulators and banks—have become internationally oriented, leading to substantive compliance with international banking standards. Finally, take the example of Bolivia: its regulators are deeply engaged in international policy discussions and regard Basel III as the gold standard for banking regulation, while the Ministry of Economy and Public Finance is more concerned with financial inclusion and domestic development than attracting foreign capital, thus grafting onto the draft legislation significant interventionist policies such as interest-rate caps and credit targets to certain economic sectors.

Analysing the reasons for adoption of Basel II and III across the developing world allows us to differentiate between the different factors that explain the decision to adopt:

• Signaling to international investors. Governments may adopt Basel standards in order to signal sophistication to foreign investors. For example, in Ghana, Rwanda and Kenya, governments have advocated for the implementation of Basel II and III, and other international financial standards, as part of a drive to establish financial hubs in their countries. However, adoption can be selective, as seen in the case of Kenya. While the Central Bank of Kenya (CBK) has sought to improve the regulatory and supervisory framework and has looked to international standards as the basis for these reforms, it has implemented the standard approach of Basel II while eschewing the advanced internal-ratings-based components. Similarly, liquidity requirements in Kenya are simpler than those of Basel III but arguably better tailored to the characteristics of the domestic banking system.
• Reassuring host regulators. Banks headquartered in developing countries may endorse Basel II or III as part of an international-expansion strategy, as they seek to reassure potential host regulators that they are well regulated at home. We see this at work in Nigeria, where large domestic banks have championed Basel II/III adoption at home as they seek to expand abroad. Their regulatory fervour has been met with reluctance among politicians who fear that a rapid regulatory upgrade may put weaker local banks in jeopardy.
• Facilitating home-host supervision. Having a common regulatory basis by adopting international standards can facilitate cross-border coordination between supervisors. In Vietnam, for example, regulators were keen to adopt Basel standards as their country opened up to foreign banks, to ensure that they had a “common language” to facilitate the supervision of the foreign banks operating in their jurisdiction.
• Peer learning and peer pressure. Even while acknowledging the shortcomings of Basel II and III, developing countries’ regulators often describe them as international “best practices” or “the gold standard”, and there is strong peer pressure in international policy circles to adopt them. In the West African Economic and Monetary Union (WAEMU), for example, regulators at the supranational Banking Commission are planning an ambitious adoption of Basel II and III with the support and encouragement of technocratic peer networks and the International Monetary Fund (IMF). Domestic banks, however, have limited cross-border exposure and show little enthusiasm for the regulator-driven embrace of Basel standards.
• Technical advice from the International Monetary Fund (IMF) and the World Bank (WB) plays an important role in shaping the incentives for politicians and regulators in developing countries. While the Financial Sector Assessment Programs (FSAPs) are designed to merely evaluate the regulatory environment of client countries against a much more basic set of so-called Basel Core Principles, there is evidence that the IMF and the WB motivate regulators in developing countries to engage in Basel II and III adoption, in some cases with explicit recommendations.

Off-the-shelf Basel II/III adoption comes with trade-offs and risks

While the reputational benefits of a full embrace of Basel II and III appear to be significant, the risks of a wholesale implementation of the global standards may be less obvious. Financial-regulatory experts in academia and policymakers assert that there is an inevitable divergence between the international Basel standards and the sui generisregulations that would be most appropriate to each jurisdiction’s economic structure, financial-regulatory framework and political preferences. This divergence is particularly stark for low- and lower-middle-income countries. The Basel Committee has recognized the need for differentiation, and while it seeks to provide a common set of minimum standards, it also allows national authorities substantial leeway in standards implementation.

Choosing the optimal approach: options for developing countries’ regulators

What steps can financial regulators in developing countries take to harness the prudential, reputational and competitive benefits of global banking standards, while avoiding the implementation risks and challenges associated with wholesale adoption?

Identify incentives and distinguish between prudential, reputational and competitive motives. In deciding whether, to what extent and how to implement Basel II and III, regulators need to establish not only what is optimal from a technical perspective, but they also need to consider how important reputational and competitive concerns are for their jurisdictions. The incentives of different groups of stakeholders—governments, regulators and financial sectors—may or may not align. Governments keen on the promotion of the country as a financial-services hub, for example, may discount the costs that an off-the-shelf Basel adoption entails both for the regulatory authority and the banking sector. On the other side, internationally oriented domestic banks may push the government to embrace Basel II/III not out of prudential concerns but because they expect to reap reputational and competitive benefits, including vis-à-vis smaller domestic rivals.

Tailor Basel standards to national circumstances.Regulatory agencies outside the Basel Committee on Banking Supervision are not bound by its rules and not subject to peer-review procedures. Regulators on the financial periphery can use this freedom to adapt global standards to meet domestic regulatory needs. In order to harness the benefits of global banking standards and reduce the risk and cost that an off-the-shelf adoption of Basel II and III entails, regulators can tailor Basel implementation to domestic circumstances in several ways.

Proportional rules implementation.Regulators can refrain from copying prudential requirements from the Basel II and III rulebook. Indonesian regulators, for example, implemented a simplified securitization framework that is adequate for the minuscule bank exposure to this market. As a member of the Basel Committee, Indonesia underwent a regulatory-consistency assessment and was deemed “largely compliant”. Peer reviewers noted that “the rules differ from the Basel framework in many respects”, but that the domestic rules are “appropriate for the nature and early stage of development of the Indonesian securitisation market”.

Thus, regulators in other countries can use their intimate knowledge of the domestic financial system to write rules that match local circumstances better than the Basel template.

References

BCBS. (2016). Regulatory Consistency Assessment Programme (RCAP) – Assessment of Basel III risk-based capital regulations – Indonesia, page 14.

This article is based on a research project led by Emily Jones, Ngaire Woods and Thorsten Beck and funded by ESRC/DFID between 2015 and 2018.