Basel Capital Reforms: Impact on Emerging Markets JANUARY 3, 2017

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The proposed changes to the Basel III capital framework could further accentuate de-risking trends by global banks, with adverse impacts on cross-border capital flows into emerging markets. In an environment of rising trade protectionism, the proposed regulatory amendments would weigh on EM growth prospects via their adverse impact on trade and project (infrastructure) finance. A retrenchment in cross-border banking flows will add further pressure on funding and hedging costs for many corporates in emerging markets.

Emre Tiftik DEPUTY DIRECTOR Global Capital Markets 1-202-857-3321 [email protected]

Jaime Vazquez POLICY ADVISOR Regulatory Affairs 1-202-857-3327 [email protected]

Jessica Stallings While EM financial institutions have avoided the worst of the financial crisis since 2008, they have been affected by the regulatory proposals and decisions by global policymaking, regulatory and standard-setting organizations. Therefore, any new regulatory approaches proposed by the official sector need to be carefully evaluated as to their relevance and suitability when applied to EM financial institutions. The proposed amendments to the Basel III capital framework could impact the various avenues available for EM borrowers to obtain finance because of their heavy reliance on bank intermediation, the prevalent role of trade credit, and the greater need for infrastructure investment. The changes to the regulatory capital framework proposed by the Basel Committee reflect a rebalancing towards simplicity and comparability at the expense of risk sensitivity, which translates into a more limited role for internal models (affecting certain portfolios, such as those of banks, large corporates, or specialized lending). From an industry perspective, these changes would lead to higher capital requirements for particular portfolios and risk types, with major changes to credit risk (both for internal models and the standardized approaches), operational risk, the Fundamental Review of the Trading Book in market risk, and the Leverage Ratio. Consequently, these changes may reduce the available liquidity for certain products and regions, particularly for emerging markets. This paper builds further on the unintended consequences of the new regulatory initiatives on emerging markets via the direct impact of capital requirements on emerging markets, and, more importantly, via the indirect impact on cross-border flows to emerging markets.1 The financial system in many emerging markets is largely bank-based, while capital markets and institutional investors, with few exceptions remain at a nascent stage of development. Another round of de-risking by foreign and domestic banks amidst regulatory amendments could be a further drag on growth via various channels in many emerging markets, several of which are still underfinanced relative to their mature market peers. This paper focuses on 1 Proposed

Basel Changes: Impacts for Emerging Market Economies, IIF, August 2016.

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FINANCIAL ECONOMIST Global Capital Markets 1-202-857-3333 [email protected]

Natalia Bailey SENIOR POLICY ASSOCIATE Regulatory Affairs 1-202-682-7440 [email protected]

Fiona Nguyen SENIOR RESEARCH ANALYST Global Capital Markets 1-202-682-7443 [email protected]

BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017

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an important subset of these channels including trade finance, cross-border banking flows, FX hedging, infrastructure investment, housing markets, and sovereign debt through which regulatory amendments could adversely affect emerging markets. However, the scope of the problem is more complex and larger than outlined in this study as there are other important channels such as the treatment of retail products and foreign exchange lending which require further analysis. CROSS-BORDER BANKING FLOWS Since the financial crisis, cross-border banking flows to emerging markets have been both weak and volatile compared to the pre-crisis-period. Deleveraging by mature market banks, driven by the global regulatory reform process, has been a big factor in the retrenchment.2 Both domestic and internationally active banks in the aftermath of 2008 crisis have been adversely affected by an increase in the cost and the availability of funding, resulting in an impact in both pricing, and portfolio/country selection. As these changes prompted a significant rise in capital requirements, banks have taken a strategic approach towards them by rethinking their geographic presence, as well as their business lines. The reduction in lending to emerging markets has been mainly attributable to BIS reporting banks (primarily mature market banks and excluding China). After reaching a record high in 2007, bank lending by mature markets to emerging markets (ex-China) fell sharply during the crisis and has recovered only modestly since then. Indeed, BIS locational banking statistics imply that major global banks in aggregate reduced their EM exposures for the second consecutive year in 2015 (Chart 1 and 2).2,3 Available data via the BIS consolidated banking statistics suggest that this decline was mostly attributable to banks in the Chart 1 Cross-Border Banking Flows to EMs (excl. China)* $ billion, loans and currency & deposits 400 BIS-reporting banks 350 Non-BIS reporting banks 300 250 200 150 100 50 0 -50 -100

Total

Chart 2 China: Cross-Border Foreign Banking Flows $ billion, loans and currency & deposits 400

BIS-reporting banks

300

Non-BIS reporting banks

200 100

Total

0 -100 -200

-300 2002

2004

2006

2008

2010

2012

2014

2016

Source: IMF, BIS, IIF. *Total banking flow figures cover bank loans and deposits based on official BOP statistics . The difference between the BIS (loand & deposits) and BOP figures is captured under the series called "others". This difference mainly represents the banking flows originated from non-BIS reporting countries.

2 For

-400

2001 2003 2005 2007 2009 2011 2013 2015

Source: PBOC, BIS, IIF. *Total banking flow figures cover bank loans and deposits based on official BOP statistics . The difference between the BIS (loand & deposits) and BOP figures is captured under the series called "others". This difference mainly represents the banking flows originated from non-BIS reporting countries.

an in-depth discussion of the factors driving global capital flows both before and after the financial crisis, see our report Financial Globalization: Maximizing Benefits, Containing Risks. 3 Banking flows comprise cross-border loans and deposits and do not incorporate other forms of external funding via banks such as foreign banks’ portfolio debt and equity investment. EM sample comprises Argentina, Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Korea, Mexico, Philippines, Poland, Russia, South Africa, Thailand, Turkey, Ukraine, and Venezuela. iif.com © Copyright 2017. The Institute of International Finance, Inc. All rights reserved.

BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017

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Euro Area, UK, and the U.S., while Japanese banks continued to increase exposure to emerging markets. However, lending by non-BIS reporting banks has been somewhat better sustained, highlighting the increasing importance of south-to-south (within EMs) banking flows for many emerging markets (See EM Cross-Border Bank Flows—New Patterns, New Vulnerabilities, July 2016). Against this backdrop, the proposed changes to the Basel III capital framework, which represent substantial increases in the minimum capital requirement for banks, could accentuate de-risking trends by global banks. In an attempt to meet new capital requirements, banks could further reduce their cross-border exposures, with adverse impacts on cross-border capital flows into emerging markets. In a rising interest rate environment where the key central banks becoming less accommodative, the negative impact could be much larger than seen in the aftermath of the 2008 crisis as higher rates across mature markets would reduce investors’ appetite for emerging market assets. In the light of this, international funding conditions for banks and corporates may tighten further, and higher short-term funding costs and monetary policy divergence across key regions could add to pressures on EM financial and non-financial corporates. TRADE FINANCE Following a modest recovery from the lows of the 2008 crisis, U.S. and European banks have reduced their trade credit flows to emerging market borrowers since 2010 (Chart 3). While this retrenchment has partly been related to the weakening global trade prospects, especially given concerns surrounding the future of China’s trade, as well as the fall in commodity prices, global banks have significantly reduced exposure to emerging markets as part of efforts to bolster capital ratios. Although some EM banks have stepped in to fill the gap by easing credit standards on domestically-intermediated trade-credit (Chart 4), tighter international funding conditions continue to pose a risk for trade credit, as many EM banks, including the regional EM banks, appear to have relatively less capacity to provide funding for cross-border trade. Chart 4 Funding Conditions for Trade Finance index, 2009Q3=100 350

Chart 3 Cross-Border Trade Credit to EMs $ billion, 4-quarter sum 80 60

300

40

250

20

0

200

-20

150

-40

International funding

100

-60

EM (excl. China)

-80 -100 2006

Domestic funding

2008

2010

China 2012

2014

50 2016

Source: IMF, IIF.

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0 Dec 09 Mar 11 Jun 12 Sep 13 Source: IIF EM Bank Lending Survey.

Dec 14

Mar 16

BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017

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With banks’ pricing models requiring an assessment of projects/products based on their risk characteristics, proposed regulatory changes—which focus on reducing the use of internal models to calculate risk-weighted assets—would undermine risk sensitivity in banks’ pricing models, as well as the regulatory capital framework. In particular, as the proposed amendments to Basel III capital rules (i) do not fully recognize the underlying risk profile for banks and large corporates, and (ii) penalize all off balance sheet exposures, the low risk characteristics of trade finance will not be adequately considered, making it a less attractive portfolio to hold for banks. Thus, an increase in capital requirements (e.g. overstating risk on higher quality transactions) would result in a reduction in the trade credit and contingent finance provided. Further impediments in access to adequate and cheaper trade credit could become particularly challenging in an environment of rising trade protectionism. BANK LENDING AND DEBT CAPITAL MARKETS The financial system in many emerging markets is largely bank-based, while capital markets and institutional investors, with few exceptions remain at a nascent stage of development (Chart 5). The growth of the EM non-financial corporate bond universe has been particularly striking over the past decade, increasing $3.4 trillion to some $4 trillion in early 2016 (Chart 6). Despite this robust expansion, domestic banks remain the primary source of funding in many emerging markets, accounting for more than half of non-financial corporate debt. In response to limits on concentration risk and the regulatory focus on asset quality, some EM banks have already tightened credit standards for corporates and strengthened monitoring of credit exposures. Higher costs of capital have reportedly pushed up lending costs in some EMs and could increase further with anticipated regulatory amendments. A potential de-risking by domestic banks amidst proposed regulatory amendments could be a further drag on bank lending given that most EM corporates and SMEs do not have external credit ratings (Chart 7). In particular, the lack of external credit ratings would

Chart 5 EM: Domestic Bank Loans percent of total non-financial corporate debt

8

6

Non-financial corporates Financial corporates

4

India S. Arabia Hungary China Turkey Czech Argentina Poland Chile Russia Israel Korea Indonesia Thailand Brazil Singapore S. Africa Hong Kong Malaysia Mexico

100 90 80 70 60 50 40 30 20 10 0

Chart 6 Emerging Markets: Corporate Bond Universe $ trillion 10

Source: BIS, IIF

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2 0 2001 Source: BIS, IIF.

2006

2011

2016

BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017

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China S. Arabia Thailand Korea Poland India Indonesia S. Africa Turkey Hungary HK Singapore Malaysia Czech Rep. Argentina Chile Mexico Brazil Russia

Chart 7 Non-Financial Corporates with No External Credit Rating percent of listed firms 100 90 80 70 60 50 40 30 20 10 0

Source: Bloomberg, IIF.

force banks to adopt a standardized approach in their lending practices and this will translate into higher capital requirements for banks. This will not only affect domestic bank lending, but will also adversely affect cross-border bank lending to emerging markets. Indeed, on average, cross-border bank credit accounts for around 15% of nonfinancial corporates’ indebtedness across the emerging markets in our sample, ranging from 3% in Israel to 50% in Hong Kong. CORPORATE HEDGING EM non-financial corporate debt (including outstanding bonds, domestic and crossborder loans) has increased rapidly and significantly, from $5 trillion in 2005 to above $26 trillion by mid-2016. While some of this is certainly attributable to China, firms in many other countries, including Turkey, Brazil, Russia, and Indonesia, have seen a substantial buildup in indebtedness. Hedging in emerging markets is necessary both to cover interest rate risk, inflation risk, etc., as well as FX risk that is becoming more common as domestic

4

100 90 80 70 60 50 40 30 20 10 0

Other foreign currencies 3

EUR USD

2

1

0 2006

Source: BI S, I I F.

2008

2010

2012

2014

2016

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Mexico Hong Kong Hungary Turkey Brazil Indonesia Singapore S. Africa Argentina Czech Rep. Poland Russia Malaysia Israel Thailand India S. Arabia Korea China

Chart 9 Currency Breakdown of Non-Financial Corporate Debt percent, Q2 2015 Other EURO USD LC

Chart 8 EM: Non-Financial Corporate FX-Denominated Debt $ t rillion

Source: BIS, IIF.

BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017

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Chart 10 EM Corporate Bonds - Industry Breakdown

Other - 9.3% Consumer - 6.3% Communications - 7.9%

Financials - 38.3%

Utilities - 8.4%

Basic Materials- 7.8%

Energy - 22.0%

Source: Market Vect ors, II F.

corporates issue debt on international markets. Despite some decline in recent years—in part reflecting the decline in demand for FX funding amidst increasing hedging costs—FXdenominated debt reached above $3.2 trillion at present or 15% of non-financial corporate indebtedness (Chart 8). The published Basel proposals heavily penalize trading activity, which includes all financial instruments used for hedging purposes by corporates and SMEs. Proposed regulatory amendments represent potential headwinds for corporates with large FX-denominated debt via their adverse impact on available international funding for hedging purposes (Chart 9). During stress-episodes, it could become even more difficult for EM corporates to turn over foreign currency debt due to the shortage of FX funding sources. Specific sectors in some countries could be at higher risk amidst a lack of natural hedges and access to derivatives markets. In particular, firms in the consumer and real estate sectors with local currency revenues and FX expenses seem to be more exposed to currency risks (Chart 10). INFRASTRUCTURE INVESTMENT World Bank estimates suggest that infrastructure investment requirements for EM economies (excluding China) will be in excess of $700 billion per year through 2020. Actual investment is projected to be around $260 billion per year during this period, implying a large gap of some $450 billion per year (Chart 11).4 A significant portion of this gap stems from South Asia and Latin America, while the gap is estimated to be lowest in MENA. By sector, electricity (nearly 40%), transport (over 30%) and telecommunications (23%) account for the largest share of investment needs, with maintenance costs making up more than half of the projected investment requirements in most of the regions (Chart 12).

4 Including

China, this amount exceeds $835 billion per year. However, World Bank figures suggest that China is overinvesting in infrastructure and inclusion of China in the estimation of the infrastructure investment gap underestimates the gap for the rest of emerging markets. iif.com © Copyright 2017. The Institute of International Finance, Inc. All rights reserved.

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With national saving rates relatively low in many emerging markets, cross-border credit continues to dominate the supply of funding for infrastructure investment. In most cases, international bank finance remains a key source of infrastructure investment, though many international banks have become more reluctant to take on this type of risk in the post-crisis regulatory environment. Like trade finance, long-term infrastructure investment in emerging markets looks vulnerable to further de-risking by foreign banks. Infrastructure investment in emerging markets is typically financed with project finance, which for regulatory purposes falls under the Specialized Lending exposure category. Under the current Basel proposals, internal models would not be allowed to assess the risk characteristics of these types of investments (i.e. highly collateralized, guaranteed by export credit agencies or governments, etc.), potentially diminishing the willingness of banks to provide infrastructure finance. As infrastructure projects are typically complex, with risks reflecting their complexity, adoption of a standardized approach in banks’ lending practices could lead to mispricing of the cost of the investment. HOUSING MARKETS Emerging markets are home to over 80% of the global population and the robust rates of population growth in many emerging markets continue to feed into higher demand for housing (Chart 13). While house prices in many mature markets remain below pre-2008 crisis levels, a vast majority of emerging markets have seen steady increases in house prices since the onset of the 2008 crisis. The surge in prices has been more pronounced in countries that have seen a significant increase in credit growth. United Nations population projections suggest that the demand for housing in many emerging markets will remain robust over the next two decades before it begins to slow down (Chart 14). Against this backdrop, the growing housing deficit in emerging markets remains a key source of concern and highlights the importance of banks in providing affordable credit to potential home buyers.

Chart 11 Emerging Markets: Infrastructure Investment Requirements $ billion, annual actual spending and investment gap over 2014-2020

Chart 12 Emerging Markets: Infrastructure Investment Requirements $ billion, annual over 2014-2020

South Asia

South Asia

Latin America

Latin America

East Asia/Pacific*

East Asia/Pacific*

Europe and Central Asia

Europe and Central Asia

Actual Gap

Sub-Saharan Africa

Capital Maintenance

Sub-Saharan Africa

MENA

MENA 0

80

160

240

320

Source: World Bank, IIF. *excludes China

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0

80

Source: World Bank, IIF. *excludes China

160

240

320

BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017

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The proposed Basel amendments for the capital treatment of Acquisition, Development, and Construction (ADC) financing would adversely impact the ability of banks to finance housing developments through the increased capital requirements for this activity. Even though financing of speculative land development and construction is normally a higherrisk activity, this needs to be considered vis a vis the broader public objective of reducing the housing deficit gap. BANKS’ EXPOSURE TO SOVEREIGN DEBT INSTRUMENTS Many EM banks hold domestic sovereign debt as high quality liquid assets to satisfy liquidity coverage ratio requirements. At around 25% on average, EM domestic banks’ share in the government debt investor base has been broadly stable while greater differentiation across jurisdictions persists (Chart 15). However, the share of foreign banks in the investor base of EM sovereign bonds has declined from 6% in 2007 to some 4% in 2015, in part reflecting the ongoing de-risking process since the 2008 crisis. The current BCBS suite of proposals explicitly excludes the treatment of sovereign debt, but foreshadows that this will be revisited in 2017, and this could have an impact on emerging markets, particularly where banks hold considerable amounts of domestic sovereign debt. Several supervisors and regulators maintain that sovereign debt is not risk free and that the sovereign-bank “vicious circle” needs to be broken as this interdependence is believed to heighten risks of financial instability. The current treatment may be modified in two ways: (i) limiting holdings of a particular sovereign’s debt within banks (concentration risk), and (ii) requiring all banks to have capital to back up those holdings. If implemented, and dependent on Basel’s final proposals, these changes could have implications for EM countries. Currently exposures to sovereigns, their central banks, and certain public sector entities are exempt from the limit, and (in several jurisdictions) do not carry any risk weight. If this changes and if successfully adopted by national regulatory authorities: Chart 13 EM Population Growth percent change over a year ago, average of 1991-2015

109

170

108

160

107

150

106

140

105

104 Egypt Malaysia Philippines Turkey Mexico India Indonesia Peru S. Africa Colombia Chile Argentina Brazil Korea China Thailand Uruguay Czech Rep. Poland Russia Hungary Ukraine Bulgaria Romania Latvia Lithuania

2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0

Chart 14 Global Population index, end-1999=100

Source: UN, IIF.

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130

103

Mature markets

102

Emerging markets (rhs)

120

101 100 2000 Source: UN, IIF.

2020

2040

2060

2080

110 100

BASEL CAPITAL REFORMS: IMPACT ON EMERGING MARKETS | JANUARY 3, 2017

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(i) we may see a cap or a penalization as sovereign exposures against a particular country exceeds the large exposure limit of eligible capital applicable. The percentage of sovereign debt to total domestic bank assets (by country) is significant, as seen in Chart 15. (ii) we may also see an impact on capital ratios of some banks, as they will be required to hold significantly more capital to back up their sovereign debt holdings (Chart 16).

Source: IMF, The Banker, IIF.

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Chart 16 Holders of Government Debt Securities % of government debt 90 80 70 60 50 40 30 20 10 0

Foreign banks Domestic banks

China Turkey Egypt Bulgaria Czech Philippines Russia Romania Hungary Poland India Malaysia Peru Thailand South Africa Brazil Argentina Mexico Chile Indonesia Latvia Lithuania Korea Uruguay Ukraine

Egypt Romania Argentina Ukraine Hungary India Poland Philippines Czech Rep. Bulgaria China Latvia Turkey Brazil Mexico Indonesia Uruguay Russia South Africa Malaysia Thailand Peru Korea Lithuania Chile

Chart 15 Domestic Banks Government Debt Holdings percent of bank assets 80 70 60 50 40 30 20 10 0

Source: IMF, IIF.