The Cost of Financial Reform for Emerging Markets

In the aftermath of the global economic crisis, financial market regulators have proposed a myriad of reforms to better govern the banking sector and to enhance its resilience to future shocks. In fact, in September 2010, a number of measures were agreed upon by the Basel Committee on Banking Supervision, an international forum designed to foster cooperation and develop standards on banking supervisory matters. The cornerstone of these reforms -- collectively known as "Basel III" -- is a commitment to stronger capital and liquidity requirements, which will ensure that banks are better able to absorb losses in the future. Other significant measures include reforms to improve supervision, risk management, governance, transparency and disclosure in the financial sector.

As I argued in a recent article, "Reviving a Policy Marriage," such a harmonization of financial supervision and macroeconomic management can be the key to happy cyclical endings in the long-term. However, concerns have been raised that the costs of moving to higher capital ratios may lead banks to raise their interest rates and reduce lending in the short-term, which can pose financing problems for emerging markets that are dependent on global banking flows.

In the most recent edition of the World Bank's Economic Premise series, authors Swati Ghosh, Naotaka Sugawara, and Juan Zalduendo examine the short-term impacts of the regulatory changes proposed under Basel III on emerging markets. In their note, "Bank Flows and Basel III -- Determinants and Regional Differences in Emerging Markets," the authors argue that "emerging markets are likely to be affected through both trade and financial flows." To be more precise, the authors' simulations show that "emerging markets will record a decline of 3 percent in banking inflows for each decline of 100 basis points in interest rate differentials."

Such changes in financial and trade flows can have significant impacts in emerging markets where financing is less readily available. To be sure, a decrease in direct loans to emerging markets could lead to a decline in investment, economic activity, and asset prices. Accordingly, while we are moving forward with financial market regulations to ensure the stability and resilience of the banking sector in the long-term, we should remain keenly aware of the potential short-term effects in emerging markets.

This blog was originally posted on the World Bank Institute Growth and Crisis website.