The Kapali Carsi

Basel III and Turkey

The biggest shocker of the crisis, at least according to your friendly neighborhood economist, is how the banks have managed to preserve themselves.

While hedge funds and private equity have lost a lot of blood in the last couple years, banks have more or less remained unscathed. Many of them are still “too big to fail” and still more like a casino, nothing like It’s a Wonderful Life’s Building & Loan – well, maybe nothing except the bank run. Moreover, those Monte Carlo activities are still mixed up with traditional retail banking, and bankers are once again earning huge bonuses.

As the public has more bloodlust against the banks than the spectators in the Coliseum, breaking them up would have been successful public relations for national governments. But I doubt that it would have been the perfect solution. Northern Rock failed not because it was colossal, but because it simply messed up its core business of managing a maturity mismatch. And the woes of the Spanish cajas suggest that a financial system with a lot of small banks is not always safer than one with a few large banks.

Here’s where Basel III comes in. To ensure that banks have enough capital when the next crisis hits, the capital requirement has been lifted to 7 percent of risk-weighted assets. This ratio will comprise of a conservation buffer of 2.5 percent to be drawn in times of stress, to be reached by 2019, in addition to the minimum common-equity target of 4.5 percent of assets, to be in place by 2015.

Even after disregarding the fact that the world will have seen a crisis or two by time the new ratios are in effect, it is debatable whether they will do the trick. Even a simple Turkey economist can see that capital ratios mean nothing if assets are overvalued, the risk agency problem remains at large, and shadow banking is still untackled. In fact, many respected economists, including Martin Wolf, argue that the new capital requirement is way too small. According to them, Basel III is unlikely to deliver a smaller and safer banking system.

But a more interesting question, at least from my own lens, is how the new rules will affect my own beloved country. To my dismay, my colleagues and Turkey economists have been dead-quiet on this question, which makes it impossible for me to plagiarize, or at least quote, them. At first glance, their silence makes sense: Not only are the rules implemented slowly, Turkish banks’ capital ratios are already above the buffer, thanks to prudential regulation after the 2001 crisis.

That argument fails to recognize the external financing costs of the new rules. Balance of Payments statistics have been pointing at a marked deterioration in the quality of external financing of late. Reining in the global banking sector would not only have a direct effect on long-term borrowing by Turkish banks, it could also impact, indirectly, foreign direct investment and portfolio flows. As a result, both the quantity and quality of external financing could be affected.

Then, standard textbook macroeconomics dictates that there needs to be either a quantity or price adjustment in the Turkish model of external finance-led growth. Simply put, either the economy would have to contract or the lira would have to depreciate.

You can argue that, with the rules not to be implemented until 2019, I am looking at the very long-run, when we will all be dead anyway. But my gut feeling is that investors are making too much of this long timeline: Market pressure could easily push the banks to the new targets in the next couple of years.

I am aware that this is not the consensus opinion, either for Turkey or the world economy. But it is much easier to make money with contrarian opinions.

Author’s Addendum:

There were quite a few issues I could not explain as much as I wanted to in my Hurriyet column about the impact of Basel III rules on Turkey, so addendum is in order:
First, I deliberately avoided naming an explicit figure for costs because I would have essentially made it up:)- that is no easy task, and definitely not a few hours’ work. But at least, I can walk you through my reasoning:
As I have identified the external financing as the main channel Turkey would get hit through Basel III, I had better explain why I think the external financing outlook is worsening. And as I always say, a picture is always better than a thousand words:
As you can see in this graph, compliments of my friends at Turkey Data Monitor, external financing has shifted from FDI and corporate borrowing to portfolio flows and banks. The former is usually deemed a less trusted source of external financing. And while banks flows are normally a good way to finance the deficit, we could see a pullback in that channel because of Basel III, as Turkish banks are borrowing from global banks.
You could generalize this point to emerging markets in general: While all would be effected by external financing drying up, those dependent on short-term speculative flows and banks would feel the heat the most. With emerging markets getting record flows following the Fed’s Quantitative Easing II, this is not an immediate concern, but certainly one we should keep at the back of our heads’ in the next couple of years.
Finally, it is worth mentioning that many details on Basel III have yet to be clarified. For example, if hybrids and other exotic stuff will not be qualified as top-notch capital, then the cost on banks will be much higher. In fact, there are already some reports that the costs on banks, especially investment banking divisions, will be significant. And some regulators, such as the Swiss and the British, are already asking their banks to hold capital in excess of the Basel rules
All in all, I would argue that it is too early to ignore Basel III, especially if you are a emerging market like Turkey dependent on bank flows for external deficit.

Originally published at Hurriyet Daily News and Economic Review and reproduced here with permission.
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