Finally, in discussing the potential measures that can be adopted by countries to mitigate procyclicality, it is important to consider the various stages of financial development in order to examine the suitability of alternative measures and the implementation issues within different national contexts. There are some general characteristics of the financial systems of developing countries that have broad implications for policy consideration, although developing countries are a very diverse set and idiosyncrasies in each country must be considered separately. What follows is a discussion of some of these general characteristics<sup>18</sup> and their implications for policy design and implementation.

# **_Dominance of the Banking Sector and Financial Market Imperfection_**

An important feature of many developing countries is the dominance of the banking sector within the financial system. This adds to concerns about risk concentration and the social costs of bank failures and banking system instability. Moreover, banks in developing countries may be exposed to larger default risk and higher loss in the event of default because information asymmetry is more severe and the legal framework and creditor rights are weaker. All these characteristics imply that risk parameters in developing countries are different from those of developed countries. Therefore, the calibration of capital and provisioning requirements should also differ, as the estimates for expected loss and variance of loss (and thus unexpected loss) differ. These considerations also relate to the question of whether some of the recently proposed measures by international standard setters (notably, capital requirements by the Basel Committee) have any binding effects for the financial sector of many developing countries. To be effective, these measures may need to be calibrated differently according to national circumstances.

# **_Different Patterns of Cycles Compared to Developed Markets_**

Developing economies exhibit different patterns of financial and economic cycles than developed countries for various reasons.<sup>19</sup> First, the trajectory of growth from a low initial point is different from that of a developed economy. Second, the observed credit expansion may be due to normal financial deepening instead of cyclical effects. Third, many developing countries (particularly small open economies) are subject to large external shocks due to cross-border capital flows or volatility in commodities prices resulted from economic conditions elsewhere, resulting in sudden boom and bust. Lastly, there is empirical evidence that financial cycles tend to be more pronounced in developing countries than developed countries and that within developing countries there are also large variations.<sup>20</sup> These characteristics imply that indicators

> 18 For a thorough discussion on the financial features of developing countries and their regulatory environment, see Agénor and Pereira da Silva (2010). The discussion in this paper is limited only to those features that are most relevant for the design and implementation of countercyclical prudential regulation.

> 19 The discussion on different patterns of cycles in developing and developed markets draws on the discussion of the BCBS consultative document, ―Countercyclical Capital Buffer Proposal‖ (BSBS 2010d) at a World Bank seminar in August 2010, particularly inputs from Michael Fuchs, Thomas Losse-Muller, Richard Hands, and Thomas Jaeggi. 20 For a discussion on the characteristics of financial cycles in Latin American in comparison to other countries, see Calderón and Servén (2011).

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