Blogback

The macroeconomic impact of Basel III on African economies

Apr 25, 2011
Africa escaped the recent global financial crisis relatively unscathed. While the region could not avoid the spillover effects of the ensuing global economic downturn, its banking sector proved generally resilient. This was mainly due to the structural reforms implemented over the past decade, including strengthening the relevant regulatory and supervisory systems, within a sounder and more flexible macroeconomic management framework.

Against this background, countries in the region need to advance their financial sector reform agenda. While financial deepening and access to financial services remain the main policy objectives, sustainable and inclusive economic growth rests ultimately on financial stability. In this context, the recent global regulatory response to the financial crisis, in particular the Basel Committee on Banking Supervision’s reform package known as Basel III offers a valuable opportunity to reexamine Africa’s financial sector reform agenda.

Basel III introduces a comprehensive set of measures which complements the Basel II and Basel I frameworks, with the aim to improve the resilience of banking systems. The cornerstone of Basel III is higher and better quality capital, mostly common equity, with improved absorption features, complemented by newly introduced liquidity requirements.

Africa is making important efforts to move to Basel II and might benefit from implementing Basel III. In spelling out a strategy to move to new standards however, it is important to assess the implications of regulatory reforms on economic performance, particularly of higher capital requirements, given their potential impact on macroeconomic outcomes. The existence of a “bank capital channel” through which changes in bank capital regulation have macroeconomic effects is well documented in the literature.

In a paper coauthored with Giovanni Caggiano from the University of Padua, we estimate the long-run impact of tightened capital ratios on African economies. Adopting a methodology used in similar studies, we quantify the gross benefits in terms of gains in African GDP resulting from a reduced probability of future banking crises. Based on existing data on the historical frequency of systemic banking crisis and associated output losses in Africa, we map higher capital ratios into reductions in the probability of crisis using a multi-variate logit model for a panel of 19 countries over the period 1980-2008. We then estimate the long-run economic costs of higher capital requirements on output assuming that an increased cost of funding is passed on fully to final customers through higher spreads. We employ two panel data for 22 countries over the period 2001-2008. In the first model, we analyze the long-run relationship between capital requirements and lending spreads. In the second model, we examine the long-term relationship between lending spreads and GDP. We finally combine the calculations so derived to quantify the net effect of higher capital requirements on the output of African economies.

We find positive net benefits from regulatory capital tightening. Starting from different levels of capitalization of the banking sector reflecting different initial conditions, net benefits for Africa are however found to be lower than those estimated for advanced economies. This is due to both lower expected gross benefits and costs for African economies, suggesting that with an already strongly capitalized banking system the marginal benefit of higher capital may be relatively moderate.

Our findings would suggest that heightened capital requirements under Basel III are not a priority for Africa. Therefore, as African countries advance their financial sector reform agenda, they might want to emphasize other areas which are equally critical to financial stability. These might include, among others: i) improving timely disclosure of high quality information, including comprehensive and internationally accepted accounting principles; ii) promoting the adoption of a sound corporate governance framework in order to achieve and maintain public trust and confidence in the banking system; iii) increasing compliance with the Basel Core Principles for Effective Banking Supervision, particularly with those requirements with which many countries are materially non-compliant, namely the independence of the supervisor and its capacity to enforce regulation and take corrective measures; iv) strengthening the relevant legal and institutional framework, introducing a crisis management system and resolution process, including a carefully designed deposit insurance system.

As a caveat, it is important considering that our results are subject to substantial uncertainties. Data and model limitations as well as the difficulty of mapping capital ratios in reductions of the probability of banking crisis are factors which inevitably affect our results. Moreover, we have omitted several elements from our analysis which may be important. Specifically, our assessment would benefit from considering the impact of higher capital requirements on African GDP volatility. Another dimension which would enrich our assessment is the expected impact on African macroeconomic performance from tightened capital rules in the rest of the world. With this in mind, our study provides a broad overview of the long-term economic impact of higher capital requirements on African economies.


Pietro Calice is a Principal Investment Officer at the African Development Bank.

Your comment

This question is for testing whether or not you are a human visitor and to prevent automated spam submissions.