In an era of shrinking resources for development finance, global policymakers must shift their focus to making better use of existing funds. Identifying and removing regulatory barriers that hinder the efficient deployment of capital to emerging markets and developing economies (EMDEs) is a good place to start.
The Basel III framework, developed in response to the 2008 global financial crisis, has played a crucial role in preventing another systemic collapse. But it has also inadvertently discouraged banks from financing infrastructure projects in EMDEs.
At the same time, advanced economies, with debt-to-GDP ratios at historic highs, face mounting fiscal pressures. Servicing these debts consumes a growing share of public budgets just as governments must ramp up defence spending and boost economic competitiveness, resulting in cuts to foreign aid.
Together, these pressures underscore the urgent need to mobilise more private capital for investment in EMDEs. Building resilient and sustainable economies will require transformational investments across the developing world in infrastructure, technology, health, and education. According to the UN Conference on Trade and Development (UNCTAD), EMDEs must raise more than $3tn annually beyond what they can raise through public revenues to meet critical development and climate targets.
Amid these challenges, prudential regulation impedes the ability of EMDEs to raise private capital. This issue can be traced back to the global financial crisis, which wiped out $15tn in global GDP between 2008 and 2011. Since the crisis stemmed from weak capital and liquidity controls, as well as the unchecked growth of innovative and opaque financial products, Basel III was designed to close regulatory loopholes and bolster oversight, particularly in response to the rise of the non-bank financial sector.
While the revised framework addresses the vulnerabilities that triggered the 2008 crisis, its focus on advanced economies and systemically important financial institutions inadvertently imposes several requirements that restrict capital flows to EMDEs.
For example, Basel III requires banks to hold disproportionately high levels of capital to cover the perceived risks of financing infrastructure projects in EMDEs. But these risks are often overestimated. The riskiest period of an infrastructure project is typically the pre-operational phase. By the fifth year, when projects begin generating revenue, risks tend to decline significantly.
In fact, the data suggest that by year five, the marginal default rates for development loans are lower than those for corporate loans extended to investment-grade borrowers. But despite the lower risk profile, banks are required to hold more capital against development-finance loans than they do against loans to unrated companies over the life of the project.
Insurers encounter similar regulatory barriers. Under the European Union’s Solvency II framework, an insurer investing in an EMDE infrastructure project faces a capital charge of 49% – nearly double the 25% required for a comparable project in an OECD country. Yet there is no empirical justification for this unequal treatment. Historical data show that infrastructure loans in EMDEs perform just as well as those in advanced economies.
The significantly higher capital costs that banks incur when making infrastructure loans to EMDEs deter them from supporting transformative, high-impact projects, steering capital toward safer, low-impact investments.
Blended finance – often touted as a promising path to de-risking EMDE investments – is also hampered by prudential regulations that impede effective collaboration between multilateral development banks and private-sector entities. MDBs, backed by guarantees from developed-economy shareholders and AAA credit ratings, can help reduce capital costs by co-financing EMDE projects and providing lenders with additional assurances. But even when MDBs share the risk, the resulting exposures often remain subject to a 100% capital charge, undermining the very benefits that multilateral engagement is meant to provide. — Project Syndicate