Ready for reforms: Developing markets are in a strong position as Basel III goes into effect

While Ghana’s financial sector has been largely insulated from the worst of the global financial crisis, it will be noticeably affected by changes in rhetoric and regulation slowly transforming the global banking system. The sector benefits from already-robust regulation and while there is scope for consolidation and increased balance sheets, the country’s lenders will need to grapple with the roll-out of new capital and liquidity requirements under the Basel regime.

However, the problems the regulations are meant to address have rarely afflicted financial markets in emerging economies, and do not necessarily take into account the idiosyncrasies of financial sectors with a preponderance of short-term deposits and limited intermediation rates, which may complicate implementation and compliance. A move by the Basel Committee on Banking Supervision in January 2013 to push back the deadline for banks to fulfil the liquidity coverage ratio from 2015 to 2019 will have softened the immediacy of the changes, but does little to address the relevance of the rules to banking markets outside Western Europe and the US.

BACKGROUND: Following the 2008 global financial crisis, a number of market participants voiced the need for increased creditable banking regulations to restrict excessive risk taking, improve transparency and avoid internal management breakdowns. Regulating banking has historically been a matter of national sovereignty, but the spread of the crisis, along with the frailties it exposed in lenders from Frankfurt to New York underlined the need for coordinated action in increasingly integrated capital markets.

BASEL III: A new set of regulations by the Basel Committee aims to tackle the roots of the sub-prime crisis by toughening capital standards and introducing stress tests. The new capital requirements, known as Basel III, will take time to be phased in but should help improve resiliency. The Basel III rules were enacted in September 2010 and proved to be the strictest seen since 1974, when nations started coordinating global financial system regulations. Expected progressively between January 2013 and December 2019, the new requirements mainly cover additional capital and liquidity. The minimum common equity requirement was increased to 4.5% of overall assets from the current 2%. An additional capital conservation buffer of 2.5% “to withstand future periods of stress” was also introduced, bringing overall equity needs to 7% of assets.

Failure to meet the standards will result in a systematic ban on dividend distribution, a measure that should help build up capital. So-called Tier 1 capital, which is made up of common equity and quasi-equity debt instruments such as convertible bonds, was raised from 4% (half of which needs to be common equity) to 6%. Liquidity requirements were to have been originally introduced in January 2015, although this has since been pushed back until 2019. To comply with the liquidity coverage ratio (LCR), financial institutions will need to have cash on hand sufficient for at least 30 days in the case of a re-run of the dried-up inter-bank lending markets during the 2009 credit crunch. The consequences of a failure to comply with liquidity rules remain to be defined.

DIFFERENT STROKES: However, given significant differences between banking systems in developed and emerging markets, such actions are difficult. The challenges affecting major retail lenders in the UK are not the same as those facing development banks in West Africa, or indeed Africa as a whole. In contrast to banks in Europe and the US, many institutions in emerging markets tend to be more conservative and traditional in their activity, limiting risk of exposure to alternative instruments.

In Ghana for example, banks tend to focus on straightforward lending, and while institutions may have heavy exposure to government treasuries, there is little in the way of riskier tools. By the same token, all but a few emerging market lenders have little in the way of long-term deposits to draw on and often lack the balance sheets to participate in large capital projects except through syndication. In fact, in some cases, the emphasis on traditional activity has been a result of equally aggressive moves by regulators to limit the adoption of riskier products. For example, in Turkey, prudent regulators have often already pushed through capital requirements surpassing Basel III.

VARIATIONS: Indeed, Tarisa Watanagase, governor of the Bank of Thailand, argued at a September 2010 conference that emerging economies need leeway in implementing the new rules. “I have a few concerns about the measures that were either announced or proposed under Basel III because of the differences between developed and emerging markets,” she said.

Dominique Strauss-Kahn, then the IMF’s managing director, said in June 2010 the global financial system is the weak link in the global economy’s recovery, with emerging markets becoming an undisputed engine for expansion. Their potential to drive the global recovery is due in part to the significant room for growth in their financial sectors. Countries like Nigeria and Indonesia boast massive populations and have competitive financial sectors, but retail penetration is still low and corporate lending is below levels of developed markets. As a result, while advanced financial markets are trying to avoid a recurrence of the subprime meltdown, banks in emerging markets are preparing to meet the needs of rapid GDP growth and an expanding population, as well as improved financial intermediation. For example, Algeria, where the banking sector already has sufficient liquidity and provisioning to absorb losses, the focus is on boosting penetration from its currently low level of 7%, rather than limiting risk in portfolios.

CHALLENGES: Even with the extended implementation deadline, there are challenges emerging markets will have to tackle to enforce Basel III. Difficulties in putting the previous set of Basel II regulations into place in markets where credit scoring is weak, such as in the ECOWAS region, already highlighted the complexities of instituting a single set of global standards – which, although needed, nonetheless risks forcing a narrow approach on markets at varying stages of development. Furthermore, while the limited range of instruments in emerging financial markets has helped avoid the excesses of the financial meltdown, this will nonetheless leave them disadvantaged under Basel III rules. For example, banks are unable to access credit default swaps in most emerging markets, which means their ability to hedge counter-party risk is limited in comparison to those of Western banks. By the same token, LCR pushes banks to maintain the necessary short-term assets by holding on to highly rated top-shelf corporate or sovereign bonds, but in most African countries, sovereign bonds are of limited utility and corporate debt is generally scarce in all but South Africa, Morocco and Egypt.

Finally, the increased costs for financing that the new regulations will incur is likely to be passed on to the consumers, which provides another hurdle, particularly in Africa where activity is lacking in part due to the fact that commercial lending rates often exceed 15% or 20%. The upside of the requirements is that banks are not only deleveraging their balance sheets to reduce the likelihood of failure, but pose less of a systemic risk to the global financial system. The downside is profitability may shrink and credit may decline.

DELEVERAGING: Since the onset of the global crisis, financial institutions began deleveraging their balance sheets by buying back debt and issuing new stock. As a result, the need to abide by capital requirements may boost the primary equity markets in emerging countries as banks flock to sell new shares. “The financial crisis forced many institutions to divest some of their non-core assets and deleverage their balance sheets, and in the past two years this constrained the expansion of large international banks in emerging markets,” Emmanuel Volland, the senior director for financial institutions at Standard & Poor’s, told OBG. “Still, the interest in frontier markets may pick up again on the back of the growth rate differential between developed and developing countries.”

The change in the LCR deadlines could slow further deleveraging, particularly from areas like Eastern Europe, which faced the issue both during the subprime fallout and again during the eurozone debt crisis. Such a slowdown would be welcome news, given that since the start of the third quarter of 2011, Eastern European deleveraging has equalled 4% of GDP.

GROWTH-RATE DIFFERENTIAL: In its April 2013 “World Economic Outlook” report, the IMF forecast growth of 6.3% in Indonesia and up to 5.6% in subSaharan Africa in 2013. Brazil, Russia, India and China, the “BRIC” countries, are projected to continue growing rapidly. That compares with the 0.3% constriction recorded in the economies of the 17 eurozone countries, a rate which was only marginally improved from a fall of 0.6% in 2012. As banks are more likely to fulfil their debt obligations, dangers to the overall system are declining. Still, systemic risk is more of an Basel III phase-in arrangements, 2013-19 issue in the West where large banks pose a liability not only to their home markets but also to the global financial system. No bank in developing markets expects to find itself included in the list of 25 “global systemically important financial institutions”.

BAILOUTS: Because lenders in emerging markets are typically of limited size, moral hazard (the propensity to seek unusual returns by taking high risks and assuming government help in distress cases) is lower than in developed markets. That is also due to the limited track record of bailouts in these countries combined with less access to high-return, speculative markets. “The fact that securitisation, derivatives markets and proprietary trading in emerging markets are not very developed drastically reduces market risk for banks and makes it easier for them to comply with Basel III requirements,” said Volland. Indeed, the prudential moves by regulators in many emerging markets to tackle capital issues and limit risky lending has meant the implementation of Basel III could prove surprisingly smooth in some ways. Malaysia, for example, is expected to be an early adopter of the new rules. The country’s central bank, the Bank Negara Malaysia, has already begun enforcing crucial regulations related to overleveraging and liquidity, and promoted a fairvalue accounting standard on financial instrument recognition and measurement.

By the same token, banks in emerging markets will likely find some Basel III requirements not only easy to comply with, but in some cases – such as securitisation – irrelevant. The simplicity of emerging banking sectors, where capital is generally composed of equity and reserves, makes limits on financial instruments unnecessary. The focus on deposits and loans defines the scope of operations at even the biggest banks, particularly in regions like Central Africa where the sector remains fragmented and suffers from a penetration rate averaging around 4%.

TIGHTENED CREDIT MARKET: Of course, while banking sectors outside of Europe and North America weathered the worst of the financial crisis fallout, thanks in part to robust regulations and a focus on ensuring safe fundamentals, slowing credit growth shows they were not immune. While credit default swaps are not an issue, and capital and provisioning ratios are generally stringent, banks in emerging markets nonetheless do face risks Basel III will help mitigate, but which may negatively impact growth rates. At a time when the global economy urgently needs stimulus, bank safety has trumped growth requirements with the Basel Committee’s decision to lift capital adequacy ratios. Combined with tighter liquidity requirements, the result is increased constraints on banks’ capacity to grant loans.

DEFAULTS: However, these constraints increased the risk of bad debts and, just like in the West, commercial banks in developing markets suffered from the economic recession after a larger number of overextended borrowers fell behind or defaulted on mortgages, car payments, consumer and credit-card loans. Non-performing loans (NPLs) have often been a problem in emerging markets, and more restrictive lending environments only drew this into sharper relief. Countries like Nigeria and Ghana have long grappled with NPLs, and while these have fallen in recent years, they still represent an obstacle and credit bureau coverage remains shallow. Other regions on the continent are no better, with banks in Algeria, Tunisia and Libya struggling with NPL ratios of up to 15%.

This has ramifications for broader economic performance in emerging markets beyond simply more constrained credit. In the corporate loan segment, a decline in loanable funds often crowds out smaller, less profitable firms, a situation likely to be problematic in emerging countries where small and medium enterprises usually account for most of the economy. Banks in emerging countries also have room to improve internal oversight, which has previously caused several bank failures, such as in Nigeria where margin lending resulted in a sector overhaul in 2009 and 2010. “Internal control processes and regulator oversight are weaker in developing than in developed markets, especially in Africa,” Abderrahim Bouazza, who oversees 86 bank examiners as head of banking supervision at the Moroccan central bank, told OBG.

RISK-RETURN: Stricter regulation reduces, in theory, the likelihood of bank failure, lowering the cost of capital and allowing banks to issue more stocks and bonds to comply with capital adequacy ratios. The planned restrictions on excessive risk may restrain profitability at banks in developed markets more than in emerging markets. Moreover, reining in earnings distribution to force banks to build more capital conservation buffers may push money managers to review where the banking industry stands in terms of risk appetite and return. However, excess cash on balance sheets is typically spent on acquisitions in emerging markets which means that going forward increased reserves may mean that more banks grow through consolidation to the point where they are too big to fail.

WORLD STANDARD: Regulatory changes, as well as innovation in creating new financial instruments, have historically been implemented in developed countries before being adopted by developing markets. Still, some options explored in Europe and the US to make the financial system more stable will probably never apply to frontier markets, especially constraints on structured finance instruments and derivatives markets. However, ideas like the Volker rule, whereby banks are precluded from engaging in proprietary trading, or the proposal of separating commercial and investment banking, might be generalised across the world. In the meantime, the debate over representation of emerging countries in global bodies has changed, now that these markets’ importance is clearer. In the ongoing overhaul of the IMF, for example, BRIC nations will be among the fund’s 10-largest shareholders once the reforms are complete. Europe will forfeit two seats on the IMF’s executive board and emerging nations will get 6% of voting rights.