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Basel Capital Reforms: Impact on Emerging Markets
JANUARY 3, 2017
Emre Tiftik DEPUTY DIRECTOR
Global Capital Markets
1-202-857-3321
Jaime Vazquez POLICY ADVISOR
Regulatory Affairs
1-202-857-3327
Jessica Stallings FINANCIAL ECONOMIST
Global Capital Markets
1-202-857-3333
Natalia Bailey SENIOR POLICY ASSOCIATE
Regulatory Affairs
1-202-682-7440
Fiona Nguyen SENIOR RESEARCH ANALYST
Global Capital Markets
1-202-682-7443
While EM financial institutions have avoided the worst of the financial crisis since
2008, they have been affected by the regulatory proposals and decisions by
global policymaking, regulatory and standard-setting organizations. Therefore,
any new regulatory approaches proposed by the official sector need to be care-
fully evaluated as to their relevance and suitability when applied to EM financial
institutions. The proposed amendments to the Basel III capital framework could
impact the various avenues available for EM borrowers to obtain finance be-
cause of their heavy reliance on bank intermediation, the prevalent role of trade
credit, and the greater need for infrastructure investment.
The changes to the regulatory capital framework proposed by the Basel Commit-
tee reflect a rebalancing towards simplicity and comparability at the expense of
risk sensitivity, which translates into a more limited role for internal models
(affecting certain portfolios, such as those of banks, large corporates, or special-
ized lending). From an industry perspective, these changes would lead to higher
capital requirements for particular portfolios and risk types, with major changes to
credit risk (both for internal models and the standardized approaches), operation-
al risk, the Fundamental Review of the Trading Book in market risk, and the Lever-
age Ratio. Consequently, these changes may reduce the available liquidity for
certain products and regions, particularly for emerging markets.
This paper builds further on the unintended consequences of the new regulatory
initiatives on emerging markets via the direct impact of capital requirements on
emerging markets, and, more importantly, via the indirect impact on cross-border
flows to emerging markets.1 The financial system in many emerging markets is
largely bank-based, while capital markets and institutional investors, with few ex-
ceptions remain at a nascent stage of development. Another round of de-risking
by foreign and domestic banks amidst regulatory amendments could be a further
drag on growth via various channels in many emerging markets, several of which
are still underfinanced relative to their mature market peers. This paper focuses on
1 Proposed Basel Changes: Impacts for Emerging Market Economies, IIF, August 2016.
The proposed changes to the Basel III capital framework could further accentuate
de-risking trends by global banks, with adverse impacts on cross-border capital
flows into emerging markets.
In an environment of rising trade protectionism, the proposed regulatory
amendments would weigh on EM growth prospects via their adverse impact on
trade and project (infrastructure) finance.
A retrenchment in cross-border banking flows will add further pressure on funding
and hedging costs for many corporates in emerging markets.
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page 2 BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017
an important subset of these channels including trade finance, cross-border banking
flows, FX hedging, infrastructure investment, housing markets, and sovereign debt through
which regulatory amendments could adversely affect emerging markets. However, the
scope of the problem is more complex and larger than outlined in this study as there are
other important channels such as the treatment of retail products and foreign exchange
lending which require further analysis.
CROSS-BORDER BANKING FLOWS
Since the financial crisis, cross-border banking flows to emerging markets have been both
weak and volatile compared to the pre-crisis-period. Deleveraging by mature market
banks, driven by the global regulatory reform process, has been a big factor in the re-
trenchment.2 Both domestic and internationally active banks in the aftermath of 2008
crisis have been adversely affected by an increase in the cost and the availability of
funding, resulting in an impact in both pricing, and portfolio/country selection. As these
changes prompted a significant rise in capital requirements, banks have taken a strategic
approach towards them by rethinking their geographic presence, as well as their business
lines.
The reduction in lending to emerging markets has been mainly attributable to BIS report-
ing banks (primarily mature market banks and excluding China). After reaching a record
high in 2007, bank lending by mature markets to emerging markets (ex-China) fell sharply
during the crisis and has recovered only modestly since then. Indeed, BIS locational bank-
ing statistics imply that major global banks in aggregate reduced their EM exposures for
the second consecutive year in 2015 (Chart 1 and 2).2,3 Available data via the BIS consoli-
dated banking statistics suggest that this decline was mostly attributable to banks in the
2 For an in-depth discussion of the factors driving global capital flows both before and after the financial crisis, see our report Financial
Globalization: Maximizing Benefits, Containing Risks. 3 Banking flows comprise cross-border loans and deposits and do not incorporate other forms of external funding via banks such as foreign
banks’ portfolio debt and equity investment. EM sample comprises Argentina, Brazil, Chile, China, Czech Republic, Hungary, India,
Indonesia, Korea, Mexico, Philippines, Poland, Russia, South Africa, Thailand, Turkey, Ukraine, and Venezuela.
Chart 1 Chart 2
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0
50
100
150
200
250
300
350
400
2002 2004 2006 2008 2010 2012 2014 2016
BIS-reporting banks
Non-BIS reporting banks
Total
Cross-Border Banking Flows to EMs (excl. China)*
$ billion, loans and currency & deposits
Source: IMF, BIS, IIF. *Total banking flow figures cover bank loans and deposits based on official
BOP statistics . The difference between the BIS (loand & deposits) and BOP figures is captured
under the series called "others". This difference mainly represents the banking flows originated
from non-BIS reporting countries.
-400
-300
-200
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0
100
200
300
400
2001 2003 2005 2007 2009 2011 2013 2015
BIS-reporting banks
Non-BIS reporting banks
Total
China: Cross-Border Foreign Banking Flows
$ billion, loans and currency & deposits
Source: PBOC, BIS, IIF. *Total banking flow figures cover bank loans and deposits based on
official BOP statistics . The difference between the BIS (loand & deposits) and BOP figures is
captured under the series called "others". This difference mainly represents the banking flows
originated from non-BIS reporting countries.
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page 3 BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017
Euro Area, UK, and the U.S., while Japanese banks continued to increase exposure to
emerging markets. However, lending by non-BIS reporting banks has been somewhat
better sustained, highlighting the increasing importance of south-to-south (within EMs)
banking flows for many emerging markets (See EM Cross-Border Bank Flows—New Pat-
terns, New Vulnerabilities, July 2016).
Against this backdrop, the proposed changes to the Basel III capital framework, which
represent substantial increases in the minimum capital requirement for banks, could ac-
centuate de-risking trends by global banks. In an attempt to meet new capital require-
ments, banks could further reduce their cross-border exposures, with adverse impacts on
cross-border capital flows into emerging markets. In a rising interest rate environment
where the key central banks becoming less accommodative, the negative impact could
be much larger than seen in the aftermath of the 2008 crisis as higher rates across mature
markets would reduce investors’ appetite for emerging market assets. In the light of this,
international funding conditions for banks and corporates may tighten further, and higher
short-term funding costs and monetary policy divergence across key regions could add
to pressures on EM financial and non-financial corporates.
TRADE FINANCE
Following a modest recovery from the lows of the 2008 crisis, U.S. and European banks
have reduced their trade credit flows to emerging market borrowers since 2010 (Chart 3).
While this retrenchment has partly been related to the weakening global trade pro-
spects, especially given concerns surrounding the future of China’s trade, as well as the
fall in commodity prices, global banks have significantly reduced exposure to emerging
markets as part of efforts to bolster capital ratios.
Although some EM banks have stepped in to fill the gap by easing credit standards on
domestically-intermediated trade-credit (Chart 4), tighter international funding conditions
continue to pose a risk for trade credit, as many EM banks, including the regional EM
banks, appear to have relatively less capacity to provide funding for cross-border trade.
Chart 3 Chart 4
0
50
100
150
200
250
300
350
Dec 09 Mar 11 Jun 12 Sep 13 Dec 14 Mar 16
Domestic funding
International funding
Funding Conditions for Trade Finance
index, 2009Q3=100
Source: IIF EM Bank Lending Survey.
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-80
-60
-40
-20
0
20
40
60
80
2006 2008 2010 2012 2014 2016
EM (excl. China) China
Cross-Border Trade Credit to EMs
$ billion, 4-quarter sum
Source: IMF, IIF.
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page 4 BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017
With banks’ pricing models requiring an assessment of projects/products based on their
risk characteristics, proposed regulatory changes—which focus on reducing the use of
internal models to calculate risk-weighted assets—would undermine risk sensitivity in
banks’ pricing models, as well as the regulatory capital framework. In particular, as the
proposed amendments to Basel III capital rules (i) do not fully recognize the underlying
risk profile for banks and large corporates, and (ii) penalize all off balance sheet expo-
sures, the low risk characteristics of trade finance will not be adequately considered,
making it a less attractive portfolio to hold for banks. Thus, an increase in capital require-
ments (e.g. overstating risk on higher quality transactions) would result in a reduction in
the trade credit and contingent finance provided. Further impediments in access to ade-
quate and cheaper trade credit could become particularly challenging in an environ-
ment of rising trade protectionism.
BANK LENDING AND DEBT CAPITAL MARKETS
The financial system in many emerging markets is largely bank-based, while capital mar-
kets and institutional investors, with few exceptions remain at a nascent stage of devel-
opment (Chart 5). The growth of the EM non-financial corporate bond universe has been
particularly striking over the past decade, increasing $3.4 trillion to some $4 trillion in early
2016 (Chart 6). Despite this robust expansion, domestic banks remain the primary source
of funding in many emerging markets, accounting for more than half of non-financial
corporate debt.
In response to limits on concentration risk and the regulatory focus on asset quality, some
EM banks have already tightened credit standards for corporates and strengthened
monitoring of credit exposures. Higher costs of capital have reportedly pushed up lending
costs in some EMs and could increase further with anticipated regulatory amendments. A
potential de-risking by domestic banks amidst proposed regulatory amendments could
be a further drag on bank lending given that most EM corporates and SMEs do not have
external credit ratings (Chart 7). In particular, the lack of external credit ratings would
Chart 5 Chart 6
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Me
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EM: Domestic Bank Loans
percent of total non-financial corporate debt
Source: BIS, IIF
0
2
4
6
8
10
2001 2006 2011 2016
Non-financial corporates
Financial corporates
Emerging Markets: Corporate Bond Universe
$ trillion
Source: BIS, IIF.
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page 5 BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017
force banks to adopt a standardized approach in their lending practices and this will
translate into higher capital requirements for banks. This will not only affect domestic
bank lending, but will also adversely affect cross-border bank lending to emerging mar-
kets. Indeed, on average, cross-border bank credit accounts for around 15% of non-
financial corporates’ indebtedness across the emerging markets in our sample, ranging
from 3% in Israel to 50% in Hong Kong.
CORPORATE HEDGING
EM non-financial corporate debt (including outstanding bonds, domestic and cross-
border loans) has increased rapidly and significantly, from $5 trillion in 2005 to above $26
trillion by mid-2016. While some of this is certainly attributable to China, firms in many oth-
er countries, including Turkey, Brazil, Russia, and Indonesia, have seen a substantial
buildup in indebtedness. Hedging in emerging markets is necessary both to cover interest
rate risk, inflation risk, etc., as well as FX risk that is becoming more common as domestic
Chart 7
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Ch
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Arg
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tin
a
Ch
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Me
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Bra
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Ru
ssia
Non-Financial Corporates with No External Credit Rating
percent of listed firms
Source: Bloomberg, IIF.
0
1
2
3
4
2006 2008 2010 2012 2014 2016
Other foreign currencies
EUR
USD
EM: Non-FinancialCorporate FX-Denominated Debt
$ t rillion
Source: BI S, I I F.
0102030405060708090
100
Me
xic
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Ho
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Ko
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Hu
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Turk
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Bra
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fric
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a
Isra
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Tha
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d
Ind
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S. A
rab
ia
Ko
rea
Ch
ina
Other EURO USD LC
Currency Breakdown of Non-Financial Corporate Debt
percent, Q2 2015
Source: BIS, IIF.
Chart 8 Chart 9
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page 6 BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017
corporates issue debt on international markets. Despite some decline in recent years—in
part reflecting the decline in demand for FX funding amidst increasing hedging costs—FX-
denominated debt reached above $3.2 trillion at present or 15% of non-financial corpo-
rate indebtedness (Chart 8).
The published Basel proposals heavily penalize trading activity, which includes all financial
instruments used for hedging purposes by corporates and SMEs. Proposed regulatory
amendments represent potential headwinds for corporates with large FX-denominated
debt via their adverse impact on available international funding for hedging purposes
(Chart 9). During stress-episodes, it could become even more difficult for EM corporates to
turn over foreign currency debt due to the shortage of FX funding sources. Specific sectors
in some countries could be at higher risk amidst a lack of natural hedges and access to
derivatives markets. In particular, firms in the consumer and real estate sectors with local
currency revenues and FX expenses seem to be more exposed to currency risks (Chart 10).
INFRASTRUCTURE INVESTMENT
World Bank estimates suggest that infrastructure investment requirements for EM econo-
mies (excluding China) will be in excess of $700 billion per year through 2020. Actual invest-
ment is projected to be around $260 billion per year during this period, implying a large
gap of some $450 billion per year (Chart 11).4 A significant portion of this gap stems from
South Asia and Latin America, while the gap is estimated to be lowest in MENA. By sector,
electricity (nearly 40%), transport (over 30%) and telecommunications (23%) account for
the largest share of investment needs, with maintenance costs making up more than half
of the projected investment requirements in most of the regions (Chart 12).
Chart 10
4 Including China, this amount exceeds $835 billion per year. However, World Bank figures suggest that China is overinvesting in
infrastructure and inclusion of China in the estimation of the infrastructure investment gap underestimates the gap for the rest of emerging
markets.
Financials - 38.3%
Energy - 22.0%
Utilities - 8.4%
Communications - 7.9%
Basic Materials- 7.8%
Consumer - 6.3%
Other - 9.3%
EM Corporate Bonds - Industry Breakdown
Source: Market Vectors, IIF.
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page 7 BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017
With national saving rates relatively low in many emerging markets, cross-border credit
continues to dominate the supply of funding for infrastructure investment. In most cases,
international bank finance remains a key source of infrastructure investment, though
many international banks have become more reluctant to take on this type of risk in the
post-crisis regulatory environment. Like trade finance, long-term infrastructure investment
in emerging markets looks vulnerable to further de-risking by foreign banks.
Infrastructure investment in emerging markets is typically financed with project finance,
which for regulatory purposes falls under the Specialized Lending exposure category. Un-
der the current Basel proposals, internal models would not be allowed to assess the risk
characteristics of these types of investments (i.e. highly collateralized, guaranteed by ex-
port credit agencies or governments, etc.), potentially diminishing the willingness of banks
to provide infrastructure finance. As infrastructure projects are typically complex, with risks
reflecting their complexity, adoption of a standardized approach in banks’ lending prac-
tices could lead to mispricing of the cost of the investment.
HOUSING MARKETS
Emerging markets are home to over 80% of the global population and the robust rates of
population growth in many emerging markets continue to feed into higher demand for
housing (Chart 13). While house prices in many mature markets remain below pre-2008
crisis levels, a vast majority of emerging markets have seen steady increases in house pric-
es since the onset of the 2008 crisis. The surge in prices has been more pronounced in
countries that have seen a significant increase in credit growth. United Nations popula-
tion projections suggest that the demand for housing in many emerging markets will re-
main robust over the next two decades before it begins to slow down (Chart 14). Against
this backdrop, the growing housing deficit in emerging markets remains a key source of
concern and highlights the importance of banks in providing affordable credit to poten-
tial home buyers.
Chart 12 Chart 11
0 80 160 240 320
MENA
Sub-Saharan Africa
Europe and Central Asia
East Asia/Pacific*
Latin America
South Asia
Capital
Maintenance
Emerging Markets: Infrastructure Investment Requirements
$ billion, annual over 2014-2020
Source: World Bank, IIF. *excludes China
0 80 160 240 320
MENA
Sub-Saharan Africa
Europe and Central Asia
East Asia/Pacific*
Latin America
South Asia
Actual
Gap
Emerging Markets: Infrastructure Investment Requirements
$ billion, annual actual spending and investment gap over
2014-2020
Source: World Bank, IIF. *excludes China
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page 8 BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017
The proposed Basel amendments for the capital treatment of Acquisition, Development,
and Construction (ADC) financing would adversely impact the ability of banks to finance
housing developments through the increased capital requirements for this activity. Even
though financing of speculative land development and construction is normally a higher-
risk activity, this needs to be considered vis a vis the broader public objective of reducing
the housing deficit gap.
BANKS’ EXPOSURE TO SOVEREIGN DEBT INSTRUMENTS
Many EM banks hold domestic sovereign debt as high quality liquid assets to satisfy liquidi-
ty coverage ratio requirements. At around 25% on average, EM domestic banks’ share in
the government debt investor base has been broadly stable while greater differentiation
across jurisdictions persists (Chart 15). However, the share of foreign banks in the investor
base of EM sovereign bonds has declined from 6% in 2007 to some 4% in 2015, in part re-
flecting the ongoing de-risking process since the 2008 crisis.
The current BCBS suite of proposals explicitly excludes the treatment of sovereign debt, but
foreshadows that this will be revisited in 2017, and this could have an impact on emerging
markets, particularly where banks hold considerable amounts of domestic sovereign debt.
Several supervisors and regulators maintain that sovereign debt is not risk free and that
the sovereign-bank “vicious circle” needs to be broken as this interdependence is be-
lieved to heighten risks of financial instability. The current treatment may be modified in
two ways: (i) limiting holdings of a particular sovereign’s debt within banks (concentration
risk), and (ii) requiring all banks to have capital to back up those holdings.
If implemented, and dependent on Basel’s final proposals, these changes could have im-
plications for EM countries. Currently exposures to sovereigns, their central banks, and cer-
tain public sector entities are exempt from the limit, and (in several jurisdictions) do not
carry any risk weight. If this changes and if successfully adopted by national regulatory
authorities:
Chart 14 Chart 13
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EM Population Growth
percent change over a year ago, average of 1991-2015
Source: UN, IIF.
100
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160
170
100
101
102
103
104
105
106
107
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109
2000 2020 2040 2060 2080
Mature markets
Emerging markets (rhs)
Global Population
index, end-1999=100
Source: UN, IIF.
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page 9 BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017
(i) we may see a cap or a penalization as sovereign exposures against a particular coun-
try exceeds the large exposure limit of eligible capital applicable. The percentage of sov-
ereign debt to total domestic bank assets (by country) is significant, as seen in Chart 15.
(ii) we may also see an impact on capital ratios of some banks, as they will be required to
hold significantly more capital to back up their sovereign debt holdings (Chart 16).
Chart 16 Chart 15
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Domestic Banks Government Debt Holdings
percent of bank assets
Source: IMF, The Banker, IIF.
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Foreign banks
Domestic banks
Holders of Government Debt Securities
% of government debt
Source: IMF, IIF.
