Policy implications: No voice, but room for manoeuvre

Regulators from LMICs had little to no influence in the formulation of global banking standards over the past four decades. Even though the Basel Committee has instituted feedback channels with developing countries such as the Basel Consultative Group and global public consultation periods, LMIC prerogatives are not likely to receive as much attention as they deserve.

The implementation of Basel II and III poses unique challenges for regulators in LMICs. Financial regulatory experts in academia and policymakers assert that there is an inevitable divergence between the international Basel standards and the sui generis regulations that would be most appropriate to each jurisdiction’s economic structure, financial regulatory setup, and political preferences. The Basel Committee has recognised 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. However, the range of options provided by the Basel Committee remains inadequate for LMICs, resulting in the adoption of overly complex regulations that are a poor match for their level of economic and financial development.

An immediate challenge arises from the sheer complexity of Basel II and III standards. Supervisory capacity is a particularly acute constraint in developing countries. To effectively supervise the standardised approach to credit risk under Basel II for instance, supervisors face the additional tasks of monitoring credit rating agencies and the appropriate use of their ratings by banks. Many countries outside the Basel Committee do not have national ratings agencies and the penetration of global ratings agencies is limited to the largest corporations.

Basel III adds another layer of complexity. Some elements of Basel III are relatively straightforward to implement, including the new definitions of capital, and the simple leverage ratio. In contrast, macro-prudential standards under Basel III require substantial regulatory resources. This is problematic because Basel III addresses financial risks that may be of limited relevance in developing countries, such as counterparty risk from derivatives transactions. Basel standards need to be adapted to reflect the main sources of financial risk in many developing countries, which often stem from external macroeconomic shocks rather than the use of complex financial instruments and a high level of interconnectedness among banks.

In light of the challenges associated with Basel II and III, the Financial Stability Board, World Bank, and IMF explicitly advise countries with limited international financial exposure and supervisory capacity constraints to “first focus on reforms to ensure compliance with the Basel Core Principles and only move to the more advanced capital standards at a pace tailored to their circumstances” (FSB, World Bank, & IMF, 2011, p. 7).

Our research leads to the following policy recommendations:

 

For regulators in LMICs

• Take advantage of the considerable maneuvering space Basel standards provide: selective implementation of Basel II and III is recommendable and widespread. A strong regulatory regime is not necessarily a complex one.

• Consider the risks of an overly ambitious Basel II/III implementation. Allocate limited supervisory capacity to address the jurisdiction’s key financial challenges, and assess to what extent Basel implementation may exacerbate reliance on credit rating agencies, information asymmetry between regulators and banks, and the exclusion of economic sectors, including small and medium enterprises.

• Tailor Basel implementation to the idiosyncratic development needs of your jurisdiction. Several components of Basel II and III presuppose financial infrastructure that may not be in place, and they address financial risks that may not be of relevance in many LMICs. 

• Implement Basel II and III selectively, focusing only on the components that address key risks in their banking sector.

• Tailor the standards when they are implemented, re-writing them rather than copying and pasting, so they are carefully adapted to local circumstances.

• Deepen mechanisms for learning from other LMIC regulators, rather than looking chiefly to international standard-setting bodies for advice; expand cross-border peer learning mechanisms to raise awareness of the benefits of proportional implementation and help regulators tailor Basel standards to the conditions and needs of their jurisdiction.

• Coordinate with other LMIC regulators and jointly advocate for changes to international standard-setting bodies, so that they better reflect the heterogeneity of financial systems around the world and the interests of LMICs.

 

For officials in international financial institutions and global standard setters

So far, the international policy community has adopted a minimalist ‘do no harm’ approach when it comes to international banking standards, seeking to establish where there have been negative unintended consequences for developing countries and only then looking for remedies. In today’s world of globalised finance, regulators in LMICs cannot simply ignore international standards even when they are not appropriately designed for their jurisdiction, as this carries significant reputational risks. As a result, resource-constrained regulators in LMICs face the choice of adopting Basel standards wholesale, knowing that this will pose problems, or taking on the onerous and challenging task of trying to retrofit Basel II and III to meet their specific regulatory needs.

Much more could and should be done at the design stage to ensure that international standards work for an LMIC context and can be readily adapted by regulators. To this end, the Basel Committee on Banking Supervision, Financial Stability Board, IMF and World Bank could take the following steps: 

• Prevent an ill-fated race to the top among LMICs towards maximum Basel II and III implementation by clarifying under which conditions proportional or non-implementation of certain Basel II and III components is recommended.

• Mandate the Basel Committee on Banking Standards to build proportionality into the design of Basel standards as a matter of course, so they can be readily tailored to a wide variety of local contexts.

• Open up the standard-setting processes to more meaningful input from LMIC representatives. At a minimum the Basel Consultative Group should include representatives from LMICs and there should be greater engagement with the Group when international standards are designed.

• Recognize the signalling function of Basel standards as a seal of regulatory quality and devise complementary methods to assess and communicate the quality of prudential financial regulation in LMICs.

• Engage in further research on the repercussions of Basel II/III implementation for credit allocation in the real economy and financial inclusion.