The following column builds on consultancy work done for the Centre for Affordable Housing in Africa (CAHF).
While global efforts to make banking systems safer and more resilient seem naturally desirable, there are concerns about potentially adverse effects on access to finance in developing countries. This column explores the likely impact of the stricter capital and liquidity standards for banks in the new Basel III framework, which are being adopted in several African countries. There are indications of clearly potential negative effects on lending, but these can be offset, at least partially, if both the regulatory authorities and the commercial banks adopt the right strategies, which depend crucially on the context.
The Basel III framework is an internationally agreed set of reform measures developed by the Basel Committee on Banking Supervision with a view to strengthening the regulation, supervision, and risk management of the banking sector. These measures raise the bar of the supervision framework relative to what was in effect before the global financial crisis (Basel I and II), essentially by introducing stricter capital and liquidity requirements for commercial banks. The objective is to reduce the probability of bank failure and thus to make the banking system safer and more resilient.
But there have been concerns about potential unintended effects on access to finance, especially in developing countries. The main contention is that the Basel III measures are designed for advanced economies and would not be a good fit in countries where banks are the main providers of formal finance to households and firms, and where there is a limited role for financial markets and non-bank financial institutions.
Another contention is that the Basel III framework is designed, in principle, for internationally active banks, and is therefore not appropriate for countries where the ‘bulk of the banking system may consist of locally incorporated banks that are not internationally active‘.
Despite these concerns, several African countries have recently adopted or are planning to adopt a set of regulatory reforms to comply with the Basel III requirements. As a case in point, the Central Bank of West African States, which covers eight West African countries, has not only adopted minimum capital and liquidity requirements in line with Basel III (with a five-year transition period from January 2018), but has also set the minimum capital adequacy ratio higher than the level required in Basel III.
To help frame policy discussions around the likely effects of Basel III on access to finance, we have reviewed findings from several studies on the issue. Here we present the key insights:
Insight 1: The Basel III regulations could lead to negative effects on bank credit supply.
These negative effects are due to the strategies that banks may adopt to comply with the higher capital and liquidity requirements. For example, banks could choose to raise additional capital and liquidity, and pass on the associated costs to their borrowers via higher lending rates or fees, which in turn could reduce demand for loans. Banks could also choose to shrink the size of their assets, especially if they face either difficulty or high costs in raising new capital and liquidity. This would result in a downward shift in the supply of loans.
Another way for banks to improve their liquidity and capital ratios would be to shift the composition of their asset portfolios towards less risky or more liquid assets – for example, by replacing high-risk-weighted loans with low-risk-weighted loans; by increasing the proportion of government bonds and other liquid assets; or by reducing the maturity of loans. The consequences for the overall volume of bank lending would be minimal, but long-term loans and loans to riskier borrowers would be disproportionately affected.
Insight 2: The adverse effects on bank lending are likely to vary substantially across banks and across countries. These variations reflect differences in a range of factors, for example:
- The pre-reform levels of bank capital and liquidity: The adverse impacts of higher capital and liquidity requirements will be minimal in countries or regions where bank capital and liquidity ratios are already high.
- The length of the transition period: Phasing in the new requirements sufficiently gradually could moderate the potentially adverse impact, since a longer transition period to the new levels of capital and liquidity stretches out the adjustment over time, and facilitates adjustment strategies based on increasing capital rather than cutting lending.
- The monetary policy response: The adverse impact could be largely offset if monetary policy is able to respond by easing monetary conditions – for example, by adjusting policy rates or by facilitating banks’ access to central bank liquidity.
- Banks’ strategies for meeting the new requirements: There are some ways that banks could adjust to comply with the new requirements without adversely affecting credit prices and availability. For example, banks could achieve a higher capital ratio through the accumulation of retained earnings rather than through downward adjustments in lending. They could also absorb any additional costs associated with the new reforms by lowering returns to shareholders or by reducing operating expenses, rather than by increasing lending rates.
- The characteristics of the economy and its financial system: Banks’ ability to charge more for their loans depends on such factors as the degree of banking competition and the elasticity of demand for loans in the economy. Their ability to achieve a higher capital ratio through retained earnings rather than through downward adjustments in lending is conditional on their profitability. The costs of meeting the new regulations are likely to be somewhat less important in an environment where banks can easily access large sums of capital and liquidity.
Insight 3: There are also potentially positive effects, as well as substitution towards non-bank lending.
Assessing the total impact of the new regulations on lending should consider not only the potentially negative impacts, but also the potentially positive effects on bank lending, as well as the substitution effects towards non-bank lending.
- Potentially positive effects on bank credit: As banks build up their capital and liquidity base to comply with the new regulations, they should become safer and more resilient. They may see a lowering in their average funding costs due to improved market confidence in their solvency. This could improve credit margins and help the growth of lending in the long run, thereby reducing the adverse impacts on bank lending.
- Effects on non-bank credit: Since non-bank financial institutions are not affected by the new regulations, they could gain competitive advantage for those activities in which they compete with banks. Substitution from bank credit to non-bank credit may therefore arise following the implementation of Basel III, and this may compensate, at least partially, for the decline in bank credit. The substitution effect is likely to be much stronger in countries with broader opportunities for substitution between forms of finance.
Taken together, these three insights suggest that whether and to what extent Basel III will have negative effects on access to finance is an open question. But importantly, the insights suggest that the negative effects can be offset, at least partially, if both the regulatory authorities and the commercial banks adopt the right strategies, which depend crucially on the context.