Anita Angelovska-Bezoska: Financial regulation, implementation and
transition effects on emerging market economies
Speech by Ms Anita Angelovska-Bezoska, Vice-Governor of the National Bank of the
Republic of Macedonia, at the Fourth OMFIF Main Meeting in Europe, Ankara,
5-6 September 2013.
* * *
Special thanks for the preparation of the background note to Ana Mitreska, Monetary Policy and Research
Department and Natasa Andreeva, Financial Stability and Banking Regulation Department. Mihajlo Vaskov and
Ljupka Georgievska also contributed to the drafting of the Note.
Background note prepared for the participation of the Vice Governor Anita Angelovska
Bezoska at the Fourth OMFIF Main Meeting in Europe, Ankara, Turkey, 5-6 September
2013.
Since the onset of the global financial crisis the financial regulatory overhaul has been
put high on the policy agenda with the aim of increasing the resilience of the banking
system and thus promoting global financial stability. Stronger banking system will be
better placed to absorb financial or economic shocks and prevent transmission of these
shocks to real economy. The regulatory reform basically addresses the lessons learned from
the crisis that insufficient capital and liquidity buffers, non-adequate on and off-balance sheet
risk coverage and excessive leverage can undermine the stability of the financial system
leading to contraction of the economic activity that can further aggravate the financial
instability and require public sector intervention to avoid full-blown banking crisis. In this vein
the reform will undoubtedly contribute to creating more sound and resilient banking system
that is a key for sustainable growth. For the emerging world, even more so amidst less
developed capital markets, as an alternative source of growth funding.
However, during the process of transition, given the still rather weak economic
recovery, the reform may have some negative implications for the financial markets,
credit activity and growth dynamics. The fact that these reforms were primarily tailored to
the specifics of the more advanced economies (AE), where the financial crisis, originally
rooted from points to a possibility of asymmetric effects for advanced and emerging
economies (EE) during the transitional process. As EE's and AE's economies intrinsically
differ in terms of the level of financial and economic development, it is to be expected for the
financial regulatory reform to have asymmetric impact on both groups of countries. Possible,
unintended adverse impact on emerging market might occur, both through the direct
of transmission (via the direct implementation of the new regulation), but also
channel
through the indirect channel, as the foreign banks in the emerging market change their
behavior in response to the new regulatory standards. The deleveraging process is one of
the well known indirect impacts, with large consequences, particularly in the emerging
Europe.
As the international regulatory reform process is very complex, some of the measures
have long sequencing of implementation, and for some of the reform areas there are
more observations and analyses to be done to define the final contours of the new
financial system, more precise assessment of the impact seems challenging.
Nevertheless the qualitative assessments and quantitative impact studies converge
toward the understanding that the global regulatory changes will impact the
availability and cost of funding in the EM in transition period. The financial structure in
the EE is rather simple, and dominated by the banking system, the retrenchment of credit
financing might impair growth prospects and the potential for job creation in the emerging
markets.
Although the reforms process is quite comprehensive and there are probably many channels
through which it can translate to the EE, still there are some key channels that I would like to
highlight.
The first point of transmission refers to Basel III capital requirements. To provide
adequate coverage of banks' risks exposure with capital, focus is placed on enhanced risk
coverage (especially trading book), higher quality and quantity of the regulatory capital, and
constraints on leverage. Overall, it appears that banks in emerging markets are well
capitalized with relatively low reliance on hybrid capital instruments, with traditional business
and no significant exposure to risks related to trading book, so significant direct impact of the
new capital requirements is not expected. But the indirect effects are perceived as important,
with possible adverse impact on the access to financing and the growth potential. Some of
the important are very well being pinpointed by the IMF (April, 2013) in
indirect implications
its scrutiny on impact of the global regulatory changes on the CESEE countries.
- The new capital requirements require balance sheet rebalancing of internationally
active banks, i.e., increase of the capital or reduction in risk weighted assets. Given the
still slow recovery process that would be an obstacle for faster increase of capital (through
reinvested earnings or new capital injections) this may have implications for the availability of
finance. One related issue is the exclusion of from consolidated group
minority stakes
capital and its implications for the process of deleverage as well as for the development and
liquidity of local equity markets (change in the nature of acquisitions).
- "Retrenchment in specialty finance due to higher risk weights for certain finance
instruments would be particularly harmful to the growth outlook of the region. Some of the
sectors most exposed to the retrenchment process are specialty finance lines, particularly
infrastructure finance and trade finance. Infrastructure finance is characterized by long
maturities, heavy use of syndication, and dependence on long-term dollar funding that makes
it particularly exposed to deleveraging"
- Cost of finance - "The cost of finance in the region could increase due to inherent
inconsistencies in the treatment of sovereign exposures at the solo and consolidated levels.
Host supervisors typically apply low risk-weighting for exposures to the host sovereign.
However under the forthcoming set of EU regulations, higher risk weights on these
exposures could result in a higher cost of finance in the host jurisdiction".
The second channel of transmission is related to the Basel III liquidity framework. As
learned from the crisis that adequate capital is necessary, but not sufficient, the Basel
III introduces internationally harmonized liquidity standards promoting internationally
The introduction of the Principles for Sound Liquidity Risk
leveled playing field.
Management and Supervision (Sound Principles adopted in 2008), Liquidity Coverage Ratio
(LCR) and the Net Stable Funding Ratio (NSFR), undoubtedly address the prior inadequate
liquidity regulation, which contributed to the crisis. The impact of the new regulation for sure
will be felt in AE and EE, but most probably the nature of it will be different. Most of the EE's
have already established sound regulatory regimes for liquidity, as a response to the
previous financial crisis within this group. But, despite the fact that the level of liquidity per se
should not be a problem there are additional dimensions through which the new liquidity
regulation impacts the EE's.
- The Basel III liquidity framework asks for very specific features of the high quality liquidity
assets, which does not always properly reflect the structure, the depth and the liquidity of the
financial markets in the emerging markets (tighter criteria compared to the existing ones in
national regulations). This mainly refers to government bonds, being treated as highly liquid
assets. Most of the emerging markets do not have deep and developed government
securities markets, which imply very limited availability of these assets, as a basis for
fulfillment of the liquidity requirements-"highly marketable" which is more restrictive than
the eligibility criteria for central bank refinancing operations (and central bank liquidity is
the most reliable form of liquidity). The options for investing in foreign securities might be
viable, but at the same time it also increases the exposure to foreign exchange risk. Some of
the countries might opt for the central bank placements as an alternative, but this is also
seen as a solution, which increases the cost of liquidity and hence, increases the costs of
finance. The problem of limited availability of proper assets also holds for corporate bonds,
which should have a proper credit rating and certain liquidity features to qualify for the LCR.
This is difficult to be fulfilled in countries with thin financial markets, and with sovereign and
hence corporate credit rating usually bellow the Basel III requirement. So measures that
restrict banks ability to finance bond holdings may hamper the further development of the
local capital markets. One remaining issue is the interaction between the LCR and the
provision of central bank facilities (The Basel Committee committed to work on this during
2013).
- The second "dimension of problems" arises from the calculation of the NSFR that
requires shift from short-term to more stable funding of assets and business
activities. Banks would have to extend the maturity of funding sources (long-term securities
or extend the maturity of loans) or convert long-term loans to short-term loans with negative
implications for the effects for the growth. Extension of the maturity of the funding structure
would also imply higher cost of financing. Within the emerging markets, the main concerns
arise from the mismatch between the funding that is actually being stable in some of the EE's
and the funding that is defined as a stable one within the Basel III regulation. Some of the
examples that we can run through are countries like Saudi Arabia and South Africa, where
the deposits of the public sector entities and the wholesale funding are the most stable one,
but are not treated as such within the new regulatory framework.
The above can be considered as direct impact of transmission of the new liquidity
framework to the EE's, but the indirect impact should not be neglected at all. The new
liquidity rules will probably change the assets structure in the balance sheets in some of the
large banks in the AE's. In a world of rapid financial integration, many of these banks have
subsidiaries in the emerging world and if the liquidity is managed on consolidated level, this
can imply possible liquidity shortages in the host country. The treatment of intra-bank
may pose challenges especially in the emerging markets where banking systems
exposures
rely markedly on the parent funding (intra-bank funding will be treated as funding from
external third parties and their maturity will have to be extended - netting out at consolidated
level is not allowed). Other question is the treatment of liquidity transfer restrictions.
Excess liquidity in one entity would not be recognized when calculating the consolidated LCR
if there is a reasonable doubt about the availability of such liquidity (due to ring-fencing
measures, non-convertibility of domestic currency, foreign exchange controls etc.).This may
lead to fragmentation of the liquidity management, replication of the treasury operations at
decentralized level with cost implications.
The growth impact of the regulatory changes is of large importance for the emerging
markets, as they aim towards financial inclusion, development of financial markets,
long-term sustainable growth and real convergence to the more AE's. Two of the most
important points which have been extensively discussed in the growth context are the
regulatory impact on trade and long-term infrastructure finance. Trade finance has been
considered as the most important facilitator of the trade flows in part of the emerging markets
and hence as an important growth factor within this group of countries. Some of the
estimates point to a figure of 80-90% of the world trade being reliant on some form of trade
finance, like trade credits or insurance/guarantees. Some of the products like the Letters of
credit have been widely used in the emerging markets and some of the estimates indicate
around 55% of all letters of credit to be related to export activities, indicating the relative
importance of trade financing in export facilitation and growth performances. Trade finance is
particularly considered to be important for SME, as an easy and chip access to financing, as
it is structured and self liquidating. Despite the large importance and the low riskiness, the
new Basel rules treat the trade finance in more conservative way, which might reduce the
availability of trade finance, increase its costs and thus impair the export and growth
prospects of the emerging markets. Albeit some amendments to the Basel rules in this area
were done in October 2011, still there are views that they are relaxed asymmetrically, only
for the importers, and as such they do not bring benefit for the emerging market exporters,
where the problems might stem from. Longer-term infrastructure finance is also treated as
important enhancer of the infrastructure project in the emerging economies, and crucial for
enhancement of their structural competitiveness. The reforms of the regulatory framework,
pose challenges in this respect as they might ask for a balance sheet rebalancing towards
more liquid assets, which can reduce the availability of infrastructure finance. In addition, the
implementation of NSFR increases the costs of infrastructure financing as it asks these types
of assets to be covered with longer term and more expensive funding.
Albeit there are many other angles within the new regulatory reform which have been
discussed in light of their consequences to the EE's (for instance policy measures for
dealing with systemically important banks, the impact of some other national and
regional reforms1, the two above elaborated dimensions of the Basel III, seem to
depict, or to be a good represent of what the main impact boils down to. Rising cost of
finance, restrained credit availability and more conservative treatment of some of the forms
of financing, crucial for the growth of EE's are the most important consequences being
discussed, which should be seriously addressed.
As for the quantitative impact studies, they do indicate a growth impact of the new
regulatory changes, though with varying intensity. While BIS Macroeconomic
Assessment Group finds rather modes effect, assessment of the International Institute
of Finance and some assessments of the banking industry point to a non-negligible
growth effects. A BBVA2 research, conducted in early 2011 estimates the impact of higher
liquidity and capital requirement on the quantity and price of credit, and hence its impact on
the GDP per capita. The estimation results point to a larger effect of the regulatory changes
on the GDP per capita of the emerging markets, compared to the one in the more advanced
countries. The results show that an increase in the capital to assets ratio by 20% reduces the
GDP per capita by 1.6% for the whole sample, and by 2.5% for the emerging markets, while
the increase of the liquid reserves to assets ratio by 20% adversely impacts the GDP per
capita by 0.4% and 0.5%, respectively. Another research, conducted by the International
Institute of Finance (IIF), a private sector institution, in 2011, finds pronounced net
cumulative impact on economic activity of the proposed financial sector reforms (both, CAR
and LCR) estimating that the level of GDP will be 3.2% lower than it would otherwise be after
five years with an output loss of 0.7% per annum. On the other hand, the analysis conveyed
by the Macroeconomic Assessment Group (MAG), which was set up by the BCBS and FSB
in 2010 with a purpose of assessing the macroeconomic effects of the new Basel III
proposals suggests a modest impact on aggregate output of the transition towards higher
capital and liquidity standards. According to MAG's assessment results, a 1 percentage point
increase in the target ratio of tangible common equity (TCE) to risk-weighted assets is
estimated to lead to a decline in the level of GDP by a maximum of about 0.19% from the
baseline path after four and a half years (equivalent to a reduction in the annual growth rate
of 0.04 percentage points over this period). Regarding the tighter liquidity requirements
(modeled as a 25% increase in the holding of liquid assets, combined with an extension of
the maturity of banks' wholesale liabilities) MAG's estimations point to a median increase in
lending spreads of 14 basis points and a fall in lending volumes of 3.2% after four and a half
years. This is estimated to be associated with a median decline in GDP in the order of 0.08%
relative to the baseline trend. An IMF study dating as of February 2012, reports similar
results to MAG's research, finding that in the absence of any monetary policy response, a
permanent synchronized global increase in capital requirements for all banks by
1 percentage point would cause a peak reduction in GDP of around 0.5 percentage points, of
which around 0.1 percentage point would result from international spillovers. Their findings
show somewhat higher losses in EMEs as compared to AEs (0.74 percentage point loss in
GDP in EMEs as compared to 0.46 percentage points in AEs) due to higher estimated
spillover effects.
The third point of transmission relates to development of financial markets EE's. The
development of deep domestic financial markets can improve the economy's ability to absorb
shocks and manage financial risks. These benefits to financial stability complement the
critical role that capital markets play in efficient resource allocation and in reducing
overreliance on the banking sector for the mobilization of savings and financial intermediation.
Additionally, diversified financial markets provide investors with alternative asset classes in
times of financial stress. However, developing such markets is a long-term process that
requires proper planning, appropriate prioritization and decisive action in several successive
stages.
Divert efforts from further development of financial markets
Financial markets in EE's have become more interlinked within the local and global financial
systems, but they are still shallow and prone to sudden price movements and greater
disruption that may undermine confidence in their integrity.
It is therefore important that
the ongoing fundamental reforms in emerging financial markets continue and that
these longer term priorities are not forgotten as a consequence of predominant
focusing on the policy response to the financial crisis and on the accomplishment of
the international regulatory reform agenda. In this sense, a decisive action is needed to
develop a domestic investor base, address market illiquidity, and improve key aspects of
market infrastructure in order to mitigate risks to emerging economies' financial stability.
Ultimately, development of bond markets, money markets and government securities
markets is the optimal route for further progress on this front. The assistance of international
partners in this area is of a key importance and should not be neglected in conditions of
growing challenges of different size and shape on both sides.
Loss of diversification benefits
Another important drawback in this regard is the initiated process of deleverage of western
banks, their more pronounced concentration on home markets and the general fragmentation
of international banking model that could deplete the financial markets of EE's, slow down
the process of their regional integration and globalization and will eliminate the potential
diversification benefits for their investors.
Incentive for further development of shadow banking
Extremely high capital and other requirements may drive banking activity into institutions or
financial arrangements that are not regulated as strongly, often referred to as "shadow
banks." This is especially pronounced in EE's where required credit growth rates to support
continued rapid economic growth and social development are much higher compared to
advanced economies (AE)3. There is near universal agreement after the financial crisis that
the shadow banking sector is potentially capable of creating massive problems and triggering
a future crisis. Therefore, there is much discussion on how to control those institutions and
types of transactions. Determining appropriate capital adequacy standards for the shadow
banking system will indeed be a key challenge in an effective redesign of the regulatory
system. A related challenge is to ensure that tighter capital standards for banks and other
highly regulated entities do not result in their simply shifting activity to less regulated areas,
including off-balance-sheet activities such as structured investment vehicles. This would
simply encourage more risk taking and raise systemic risk as well, since many
off-balancesheet activities could end up being effectively on-balance sheet at times of crises. However,
the truth is that we are far from completely figuring out how to control these institutions and
types of transactions and it is unlikely that there will be an approach clever enough to provide
the same level of systemic protection in regard to shadow banks as there will be for highly
regulated entities.
Conclusion
When scrutinizing the impact of the regulatory changes on the EE's, there are no doubts
that the reform process is an important qualitative step forward for the overall
financial industry and its implementation will mean more stable financial sector, lower
probability of financial crisis and less "headaches" for the authorities responsible for
macroeconomic and financial policies. Yet, apparently, there are many angles within the
new regulation which should be further well screened and assessed in terms of their
potential adverse impact, especially in emerging markets due to different challenges. And
as the EE's are currently the main engine of growth in the world economy, and the economic
prospects of the advanced world are highly conditioned on the economic health of emerging
countries, it appears that this is a question of a mutual interest. Improving the home-host
cooperation to avoid conflicts of interest between home and host supervisors may also help
in mitigating the possible adverse effects.
What I have talked above, for sure does not exhaust all the issues, but I think it gives a map
of the main points which are being heavily discussed, as they can possibly impair the
financial and economic prospects of the EE's. By now, many shortcomings of the reforms
have been identified, and efforts for addressing some of them have already been made. But,
the timeline of the financial regulatory changes is rather long. Hence, a continuous
discussion on the characteristics of the proposed financial reforms is of a great importance.
Discussions and forums in this area can help for a timely identification and removal of the
possible weaknesses that can easily evolve into causes of a next (global) financial crisis.