Ever More Financial Instability Notwithstanding the Basel Standards and the IMF’s Financial Sector Assessment Program

Abstract

Asian crisis in the late 1990s exposed the inherent deficiencies of Basel I, and exactly a decade later the 2008 global credit mayhem clearly proved that the Revised Framework (Basel II) and the IMF’s Financial Sector Assessment Program contributed to instability rather than averting high-magnitude future crises. The propagation of financial turmoil and the subsequent crises in this millennium has made safeguarding of global financial stability the utmost task of government authorities worldwide. The stringent new Basel III reforms have become a central focus in the post-GFC to strengthen the observed weaknesses under both Basel I & II. While proponents argue that higher capital ratios will help alleviate or eliminate the exorbitant costs of crises, opponents fear that the stricter capital rules along with tighter liquidity may cause a contraction in credit markets and inhibit economic activity. The study employs DSGE and VECM models to estimate the cost impact of the regulatory tightening on bank capital, lending spreads, and steady state output across ASEAN-5 and Turkey. Based on our methodology, our estimates show that in the aggregate the banking sectors of ASEAN-5 as a whole need to raise $111.37 billion of fresh capital to meet our target 24% CAR of RWAs, Turkey’s banking sector needs to come up with little over $32 billion. At this background, ASEAN-5 and Turkish banks would be forced to raise their lending spreads on average by circa 20 bps 50 bps. To meet the Basel III regulatory minima by the January 2019 deadline, banks would have to increase lending spreads on average by about 70 bps across ASEAN-5 and 636 bps in Turkey. After a 4-year implementation, we estimate that a 1 pp rise in the CET1/RWAs without any liquidity tightening results in output loss of -0.07% per annum for ASEAN-5 economies and -0.18% for Turkey. However, this paper concludes that economic benefits of Basel III outweigh its economic costs in the long-run.

Keywords: Basel III, Financial Sector Assessment Program, Financial Stability, IMF, ASEAN-5, Turkey

JEL Classification: C32, C53, E44, E61, G18, G21, G28, G32