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Banks in emerging markets: the need for a separate reform agenda

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In Brief

Banks in emerging markets are normally considered high risk, while banks in developed countries are generally thought to be robust and well regulated — but the 2008 global financial crisis suggests the opposite.

Financial markets should have recalibrated their scales for measuring risk following the crisis, but this has not yet happened.

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Instead, the IMF warned of dangers to emerging-market banks late last year, while Moody’s revised its outlook on India’s banking sector from stable to negative. A careful reassessment of risk is needed, not a mechanical association of emerging-market banks with the vulnerabilities of other banks around the globe.

Emerging-market economies have been considerably strengthened since the 1997 Asian financial crisis, through better macro-stabilisation and other reforms. Exposure to cross-border risks and doubtful sovereign debt has been limited, and high-leverage, short-term funding and risky endogenous expansion of balance sheets — which led to the global financial crisis — have been absent.

In India, too, the path of steady market development and regulatory evolution reduced risks. Structural ratios, such as the rate of return on assets, registered improvement and the percentage of gross non-performing assets (NPAs) in the banking sector reached a low of 2.4 in 2009–10, compared with 12.8 in 2000. A new philosophy of regulation — a shift from interfering with individual transactions to macro-management based on broad sectoral exposures (such as higher provisioning on lending to real estate) — appears to have generated incentives that reduced pro-cyclical behaviour in financial markets.

Indian regulators aimed to comply with Basel II capital adequacy regulation norms based on the banking sector’s own risk assessments in the mid-2000s. But in the absence of relevant skills among Indian banks, the required depth of data and market-determined parameters were missing. So, by default, they successfully followed capital adequacy regulations based on broad sectoral exposures, instead of the mathematical models preferred by other global banks that often aggravate risk taking in economic booms.

Still, risks with emerging-market banks remain, especially since many are surfacing from a period of financial repression and government ownership, and typically operate in narrow financial markets and higher-inflation regimes. While many of these structural risks are no longer a concern for Indian banks, cyclical risks — such as a sharp rise in interest rates — have recently increased. These have contributed to other risks such as rising NPAs and falling growth in banks’ net interest income.

But the cyclical risks confronting emerging-market banks may have peaked with the pause in rate hikes and the reduction in exchange-rate volatility, and they can be contained as long as macroeconomic policy helps moderate large fluctuations in asset prices. This is especially so because of thin markets, higher levels and spreads of interest rates, and higher pass-through because of a less competitive banking sector.

Large fluctuations in exchange rates due to capital flows driven by external shocks also create risk, and policy makers in emerging markets need to smooth out such fluctuations. But advice from international institutions to sharply raise interest rates and allow exchange rates to float freely creates the risks they precisely warn against. Such advice lacks understanding of the unique context in which emerging-market banks operate, as was demonstrated during the Asian financial crisis.

The steady development of institutions and markets — which has allowed for market-determined interest and exchange rates, reduced their volatility, improved monetary transmission and imposed some discipline on governments — should be maintained. This said, policy goalposts cannot remain the same after the global financial crisis. Awareness about these issues is essential, since the markets tend to mechanically punish any deviation from advanced-country norms. Emerging-market banks have to continue to modernise, but an ideal regulatory system would include regulation based on broad ratios. Similar features could also resolve global regulatory reform problems, such as too much regulatory discretion and delayed response to systemic risk.

The highly bank-based Basel III regulatory stance is a problem for emerging markets given that their financial systems are bank dominated and already have strong regulation and taxes, but are yet to reach scale. Also, a bank’s assets are typically less than its output in emerging-market economies, compared to the reverse in developed countries, and international shadow banks — which generate volatile flows to emerging markets — currently escape regulation. Rather than contributing to risk, emerging markets are at the receiving end of such flows and international institutions should focus on moderating these risks first and foremost.

Ashima Goyal is Professor of Economics at the Indira Gandhi Institute of Development Research, Mumbai.

This article was first published here at The Hindu Business Line.

One response to “Banks in emerging markets: the need for a separate reform agenda”

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