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Basel III & Unintended Consequences for Emerging Markets and Developing Economies - Part 3: An Unlevel Playing Field Between Domestic and Foreign Banks Might Increase Governments’ Funding Costs

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This blog is the third in a series on the effects of Basel III on Emerging Markets and Developing Economies (EMDEs) based on the analysis of a CGD Task Force exploring these issues. The first one on cross-border spillovers can be accessed here, and the second on trade finance can be found here.

Responding to the latest assessment of Mexico’s implementation of the Basel III recommendations, the Mexican authorities argued that regulations for countries hosting foreign banks’ subsidiaries and for the parent countries of the subsidiaries should be aligned “in order to prevent distortions due to the asymmetric treatment of similar risk exposures by home and host jurisdictions,” which could result in an unlevel playing field between foreign subsidiaries and domestic banks. In particular, they cited home country regulations and criteria for treating Mexican sovereign exposures taking precedence over host country regulations as a concern.

Like Mexico, many emerging markets and developing economies (EMDEs) experience large participation of global banks in their local financial systems. For example, in countries such as Poland, Botswana, and Uganda, the participation of foreign banks, measured by their share in total local banking assets, exceeds 70 percent (see the below chart). They would likely sympathize with Mexico on the issue of a potential unlevel playing field emerging between domestic and foreign banks resulting from Basel III recommendations.

Percentage of Foreign Bank Assets Among Total Bank Assets (Selected EMDEs)


Source: Claessens and Van Horen, 2015

Advanced Economies Move Ahead with Implementation, While EMDEs Lag Behind, Causing Regulatory Discrepancies between Domestic Banks and Foreign Subsidiaries

Since recommendations under Basel III are primarily directed to internationally active banks, most home supervisors of global banks have moved promptly to comply with the accord, while few EMDEs are in the process of implementing it and many have not even started. Large differences in regulatory/supervisory frameworks impose costs to the operations of foreign banks in EMDEs who have to meet both home and host requirements. This regulatory mismatch factors into global banks’ cost-benefit analysis of doing business with EMDEs, as discussed in the first blog, and generates disincentives for global banks to increase their presence in EMDEs. As has been extensively discussed in the literature, subsidiaries of foreign banks play an important role in financing growth and development, stabilizing credit flows, and increasing business formation in EMDEs.

In addition, the process of implementation of Basel III in global banks might bring about several unanticipated, adverse consequences to financial stability in the countries that host subsidiaries from global banks. In this blog, I discuss one of these unintended results: the potential decreased role of foreign subsidiaries as liquidity providers of EMDEs’ government securities, which in turn might increase the financing costs of EMDEs’ governments.

How Regulatory Mismatch Might Increase Financing Costs of EMDEs’ Governments

There are two regulatory factors that might lead to this outcome. The first is that home supervisors of global banks require that regulations are applied and enforced on a consolidated basis; that is, obligations of compliance of a global bank with Basel III requirements apply to the entire banking group, including its foreign branches and subsidiaries. Therefore, home-country regulations dominate over those of host-countries. For example, if exposures to Mexican securities denominated in pesos are considered foreign currency exposures by a foreign parent bank, they will also be treated as foreign currency exposures by the subsidiaries of that bank, regardless of where the subsidiary is operating. This might result in a Mexican government security being treated as a local currency exposure by Mexican domestic banks and as a foreign-currency exposure by foreign subsidiaries operating in Mexico.

The second regulatory factor is that in the calculation of banks’ capital requirements, most EMDEs use the so-called standardized approach, which following Basel III, allows national authorities to apply a zero risk weight to banks’ exposures to their sovereign of incorporation when the exposures and denominated and funded in local currency (these assets are considered the safest since sovereigns defaults of liabilities denominated in their own currencies are very rare events—most sovereign debt crises involve liabilities denominated in foreign currency). In contrast, global banks use their own internal models which, by treating EMDEs’ sovereign paper as foreign-currency denominated exposures in their calculation of capital requirements, might attach higher risk weights (greater than zero) to these securities.

Thus, with respect to the regulatory treatment of government securities denominated in local currency, the combined effects of home-country consolidated supervision and the use of internal models by global banks might result in unwarranted higher capital requirements for foreign subsidiaries than for domestic banks incorporated in an EMDE.  

Next Steps

Aware of this issue and the problems that it entails for the development and stability of EMDE’s financial systems, the Basel Committee undertook a review of the regulatory treatment of sovereign exposures, but has yet to make any changes to their treatment. Moreover, home and host country regulatory issues go beyond the case of sovereign exposures discussed here. Country supervisors may need to address these problems themselves if no regulatory changes are forthcoming at the global level.

The next blog in this series will discuss challenges posed by the implementation of Basel III in EMDEs on the financing of infrastructure projects and small- and medium-size enterprises (SMEs).

Disclaimer

CGD blog posts reflect the views of the authors drawing on prior research and experience in their areas of expertise. CGD does not take institutional positions.