Basel Standards and Developing Countries – a Difficult Relationship
The global prudential standards issued by the Basel Committee on Banking Supervision represent major efforts to increase the resilience of banking systems around the world and thus reduce the likelihood of another systemic financial crisis. But most Basel standards are developed by and for Basel Committee members, representing major advanced and emerging economies only. Regulators in many low and lower middle-income countries are pressing ahead with the implementation of Basel II and III even though these standards are an imperfect match for the risk profile and level of development of their domestic banking systems.
Implementation of the first Basel standard is almost ubiquitous, and the newer two standards – Basel II and III – have found widespread acceptance beyond the perimeter of the Basel Committee. Data from Financial Stability Institute (2015) at the Bank of International Settlements show that 90 out of 100 surveyed non-member jurisdictions have implemented Basel II at least partially or are in the process of doing so. Moreover, 81 jurisdictions reported that they had taken steps towards the implementation of at least one component of Basel III.
Given that Basel standards are costly to implement and are an imperfect match for the risk profile and level of development of financial sectors in many developing countries, why have these countries adopted them? Our 3-year research project combines cross-country panel analysis and in-depth case studies of the political economy of the adoption of Basel II/III to provide important insights into the factors that explain why or why not regulators in developing countries adopt and implement international regulatory standards.
Reputation and Competition Concerns Drive Basel Implementation
Regulators in developing countries do not merely adopt Basel II/III because these standards provide the optimal technical solution to financial stability risks in their jurisdictions. Instead, we find that the following factors also drive the adoption of Basel II/III:
Signalling to international investors. Incumbent politicians may adopt Basel standards in order to signal sophistication to foreign investors. For example, in Ghana, Rwanda, and Kenya, politicians have advocated the implementation of Basel II and III, and other international financial standards, as part of a drive to establish financial hubs in their countries. However, adoption can be selective, as seen in the case of Kenya. While the Central Bank of Kenya (CBK) has sought to improve the regulatory and supervisory framework and has looked to international standards as the basis for these reforms it has implemented the standard approach of Basel II while eschewing the advanced, internal-ratings based components. Similarly, liquidity requirements in Kenya are simpler than those of Basel III but arguably better tailored to the characteristics of the domestic banking system.
- Reassuring host regulators. Banks headquartered in developing countries may endorse Basel II or III as part of an international expansion strategy, as they seek to reassure potential host regulators that they are well-regulated at home. We see this at work in Nigeria, where large domestic banks have strongly supported Basel II/III adoption at home as they seek to expand abroad. Their regulatory fervour has been met with concerns by regulators who fear that a rapid regulatory upgrade may put weaker local banks in jeopardy.
- Facilitating home-host supervision. Adopting international standards can facilitate cross-border coordination between supervisors. In Vietnam, for example, regulators were keen to adopt Basel standards as their country opened up to foreign banks, to ensure they had a ‘common language’ to facilitate the supervision of the foreign banks operating in their jurisdiction.
- Peer learning and peer pressure. Even while acknowledging the shortcomings of Basel II and III developing countries regulators often describe them as international ‘best practices’ or ‘the gold standard’ and there is strong peer pressure in international policy circles to adopt them. In the West African Economic and Monetary Union (WAEMU), for example, regulators at the supranational Banking Commission are planning an ambitious adoption of Basel II and III with the support and encouragement of technocratic peer networks and the IMF. Most domestic banks however have limited cross-border exposure and show little enthusiasm for the regulator-driven embrace of Basel standards.
- Technical advice from the International Monetary Fund and the World Bank plays an important role in shaping the incentives for politicians and regulators in developing countries. While the Financial Stability Assessment Programs (FSAPs) are designed to merely evaluate the regulatory environment of client countries against a much more basic set of so-called Basel Core Principles, we find evidence that Fund and the Bank motivate regulators in developing countries to engage in Basel II and III adoption, in some cases with explicit recommendations.
Choosing the Optimal Approach: Options for regulators in developing countries
What steps can financial regulators in Low and Middle Income Countries (LMIC) take to harness the prudential, reputational and competitive benefits of global banking standards, while avoiding the implementation risks and challenges associated with wholesale adoption? Our research highlights several options for regulatory agencies in LMICs. Here we focus on two that relate directly to the findings discussed above.
Identify incentives and distinguish between prudential, reputational, and competitive motives. In deciding whether, to what extent, and how to implement Basel II and III, regulators need to establish not only what is optimal from a technical perspective, but they also need to consider how important reputational and competitive concerns are for their jurisdiction. Our research shows that three groups of domestic stakeholders shape the degree of Basel standards adoption in developing countries: incumbent politicians, regulators, and the banking sector. The incentives of each group of stakeholders may or may not align. Incumbent politicians keen on the promotion of the country as a financial services hub for example may discount the costs that an off-the-shelf Basel adoption entails both for the regulatory authority and the banking sector. On the other side, internationally oriented domestic banks may push the government to embrace Basel II/III not out of prudential concerns but because they expect to reap reputational and competitive benefits, including vis-à-vis smaller domestic rivals.
Tailor Basel standards to national circumstances. Regulatory agencies outside the Basel Committee on Banking Supervision are not bound by its rules and not subject to peer review procedures. Regulators in the financial periphery can use this freedom to adapt global standards to meet domestic regulatory needs, as some but not all are already doing.
More information on the study insights is available on the GEG (Global economic Governance) Programme website.
About the Authors
Thorsten Beck is Professor of Banking and Finance, Cass Business School
Florence Dafe is a Fellow in International Political Economy at the Department of International Relations at the London School of Economics
Emily Jones is Associate Professor of Public Policy, Blavatnik School of Government, University of Oxford
Peter Knaack is Senior Research Associate, Blavatnik School of Government, University of Oxford.