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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 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 emerging markets and developing economies.

At the same time, advanced economies, with debt-to-gross domestic product ratios at historic highs, face mounting fiscal pressures. Servicing these debts consumes a growing share of public budgets just as governments must ramp up defense spending and boost economic competitiveness, resulting in cuts to foreign aid.

Together, these pressures underscore the urgent need to mobilize more private capital for investment in emerging markets and developing economies. 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, emerging markets and developing economies must raise more than $3 trillion 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 emerging markets and developing economies to raise private capital. This issue can be traced back to the global financial crisis, which wiped out $15 trillion 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 nonbank 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 emerging markets and developing economies.

For example, Basel III requires banks to hold disproportionately high levels of capital to cover the perceived risks of financing infrastructure projects in emerging markets and developing economies. But these risks are often overestimated. The riskiest period of an infrastructure project is typically the preoperational phase. By the fifth year, when projects begin generating revenue, risks tend to decline significantly.

In fact, the data suggests 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 EU’s Solvency II framework, an insurer investing in an emerging market and developing economy infrastructure project faces a capital charge of 49 percent — nearly double the 25 percent required for a comparable project in an Organisation for Economic Co-operation and Development country. Yet there is no empirical justification for this unequal treatment.

Historical data show that infrastructure loans in emerging markets and developing economies perform just as well as those in advanced economies.

Even when multilateral development banks share the risk, the resulting exposures often remain subject to a 100 percent capital charge.

Vera Songwe, Jendayi Frazer and Peter Blair Henry

The significantly higher capital costs that banks incur when making infrastructure loans to emerging markets and developing economies 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 investments to emerging markets and developing economies — is also hampered by prudential regulations that impede effective collaboration between multilateral development banks and private sector entities. Multilateral development banks, backed by guarantees from developed economy shareholders and AAA credit ratings, can help reduce capital costs by co-financing projects in emerging markets and developing economies and providing lenders with additional assurances. But even when multilateral development banks share the risk, the resulting exposures often remain subject to a 100 percent capital charge, undermining the very benefits that multilateral engagement is meant to provide.

Moreover, only a limited number of multilateral development banks currently qualify for zero percent risk weighting under Basel III. Expanding the list would enable commercial banks to work with a broader range of multilateral development banks, increasing the impact of each taxpayer dollar invested in development aid. Compounding the problem, even eligible multilateral development banks are required to provide an “unconditional” guarantee for a zero percent risk weight to apply. But it remains unclear how regulators define unconditional and this ambiguity prevents commercial banks from making full use of multinational development bank risk-sharing tools.

To be sure, Basel III’s foundational principles are sound. Capital buffers and liquidity ratios that reflect institutional risk profiles are essential for maintaining financial stability. But several rules within the otherwise well-designed Basel III framework limit emerging markets and developing economies’ ability to pursue sustainable development while doing little to mitigate systemic risk. At a time when net capital inflows to emerging markets and developing economies are declining due to debt-service obligations to advanced-economy creditors, prudential regulations must not inadvertently impede private capital flows to productive projects in these countries.

To improve the regulatory framework for emerging markets and developing economies, the G20 must take four key actions as a platform for cooperative leadership.

First, recalibrate capital requirements for infrastructure project finance to reflect real-world default performance, particularly in the postconstruction phase.

Second, expand the list of multilateral development banks eligible for zero percent risk-weighting under Basel III to include high-performing regional institutions, such as the Africa Finance Corporation, which have investment-grade ratings.

Third, clarify the definition of “unconditional guarantees” so that more multilateral development bank-backed risk-sharing instruments can qualify for favorable regulatory treatment. And lastly, introduce capital charge discounts for blended finance structures co-financed by A-rated institutions, with the level of discount varying by rating.

These reforms do not require new taxpayer commitments; they simply align regulation with actual risk. Implementing them would crowd in more private investment, reduce borrowing costs for developing countries and accelerate progress toward transformative development that creates much-needed jobs. The G20 must address these regulatory roadblocks so that capital can flow to where it delivers the greatest value.

Reaching consensus on how to lower capital costs for emerging-market economies is one of the top priorities for G20 finance chiefs. Reforming the Basel III framework would be a relatively low-cost, high-impact way to mobilize investment, drive job creation and support sustainable growth.

• Vera Songwe, a former executive secretary of the Economic Commission for Africa and UN under-secretary-general, is a nonresident senior fellow at the Brookings Institution, Founder and Chair of the Liquidity and Sustainability Facility, and Co-Chair of the Expert Review on Debt, Nature, and Climate.
• Jendayi Frazer, a former US Assistant Secretary of State for African Affairs, is a visiting fellow at the Hoover Institution.
• Peter Blair Henry is the Class of 1984 Senior Fellow at the Hoover Institution. ©Project Syndicate