The Dark Side of Implementing Basel Capital Requirements: Theory, Evidence and Policy

Abstract

Most financial systems around the world have imposed new capital requirements for banks in the past years. This policy seems to be justified on two powerful economic grounds. First, better capitalized banks promote financial stability by reducing banks’ incentives to take risks and increasing banks’ buffers against losses. Second, lack of compliance with a set of rules established by the Basel Committee may harm confidence on a country´s financial system. While acknowledging these potential benefits, this paper makes the often overlooked point that the full implementation of Basel capital requirements may be socially undesirable for poorer countries seeking to develop their economies. On the one hand, higher capital requirements may reduce people´s access to finance, which can be particularly problematic in emerging countries with less developed capital markets and greater problems of financial exclusion. On the other hand, the one-size-fits-all model incentivized by the Basel Committee does not take into account many emerging countries’ social and economic markets, infrastructures and priorities. In our opinion, the presence and power of certain countries in the Basel Committee makes Basel recommendations partially biased toward those problems existing in these jurisdictions. Based on the aforementioned problems, this paper suggests some policy recommendations to promote a more resilient financial system without hampering financial inclusion and economic growth.

Keywords: capital requirements, Basel Accords, Basel III, Basel Committee, financial regulation, access to finance, tax benefits of debt, financial inclusion, economic growth.