Wednesday, December 14, 2011

Banking flows and financial interconnectedness and basel III effects

This paper examines the factors that determine banking flows from advanced economies to emerging markets. In addition to the usual determinants of capital flows in terms of global push and local pull factors, it examines the role of bilateral factors, such as growth differentials and economic size, as well as contagion factors and measures of the depth in financial interconnectedness between lenders and borrowers.

The analysis finds profound differences across regions. In particular, in spite of the severe impact of the global financial crisis, banking flows in emerging Europe stand out as a more stable region than is the case in other developing regions. Assuming that the determinants of banking flows remain unchanged in the presence of structural changes, the authors use these results to explore the short-term implications of Basel III capital regulations on banking flows to emerging markets.

I. Introduction

The global financial crisis has led to a range of reform proposals concerning the regulatory framework governing the banking sector with a view to enhancing its resilience. Agreement has already been reached on some aspects of these new rules, which are collectively referred to as Basel III (Appendix 1). The proposed new regulations cover both micro-prudential or firm-specific measures, as well as macro-prudential measures aimed at strengthening the resilience of the banking system as a whole by addressing the pro-cyclicality of banking and limiting the risks arising from the interconnectedness among financial institutions.

One of the cornerstones of the proposed reforms relates to strengthening the level and quality of the capital base through an increase in the minimum common equity requirement from 2.0 percent to 4.5 percent of assets and the introduction of a capital conservation buffer of 2.5 percent of assets. Within the proposed macro-prudential reforms, agreement has also been reached on the introduction of counter-cyclical capital buffers. To contain the excessive buildup of leverage, agreement has also been reached on introducing an internationally harmonized leverage ratio threshold that could serve as a backstop to the capital measure and on a new global minimum liquidity standard.

Although the proposed reforms are expected to generate substantial benefits (namely, by reducing the frequency and intensity of banking crises), concerns have been raised that, in the short term, the costs of moving to higher capital ratios may lead banks to raise their lending rates and reduce lending.1 In particular, if these regulations are implemented over a short period of time, there could be a consequent drag on the economic recovery in countries adopting these regulations as well as in those emerging markets closely dependent on global banking flows.

Against this background, this paper examines the determinants of banking flows from advanced economies to emerging markets. It focuses primarily on the nature of the financial linkages between these countries after controlling for global push and local pull factors, as well as aggregate bilateral linkages. These results are then used to assess the possible impact on emerging markets of the regulatory changes under Basel III. We focus primarily on the financial flows channel; that is, the impact on banking flows through both direct and indirect lending.

World Bank.Author:Ghosh,,Swati R.;Sugawara,Naotaka; Zalduendo,Juan.Document Date:  2011/08/01.Document Type: Policy Research Working Paper.Report Number: WPS5769.Volume No:1 of 1