Basel III Basel III is a global, voluntary regulatory
standard on bank capital adequacy, stress testing and market liquidity risk.
It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11,
and was scheduled to be introduced from 2013 until 2015; however, changes from 1 April
2013 extended implementation until 31 March 2018.
The third installment of the Basel Accords was developed in response to the deficiencies
in financial regulation revealed by the late-2000s financial crisis.
Basel III was supposed to strengthen bank capital requirements by increasing bank liquidity
and decreasing bank leverage.
General Overview Unlike Basel I and Basel II which are primarily
related to the required level of bank loss reserves that must be held by banks for various
classes of loans and other investments and assets that they have, Basel III is primarily
related to the risks for the banks of a run on the bank by requiring differing levels
of reserves for different forms of bank deposits and other borrowings.
Therefore contrary to what might be expected by the name, Basel III rules do not for the
most part supersede the guidelines known as Basel I and Basel II but work alongside them.
Key principles Capital requirements
The original Basel III rule from 2010 was supposed to require banks to hold 4.5% of
common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel
II) of "risk-weighted assets" (RWA).
Basel III introduced "ad æitional capital buffers", (i) a "mandatory capital conservation
buffer" of 2.5% and (ii) a "discretionary counter-cyclical buffer", which would allow
national regulators to require up to another 2.5% of capital during periods of high credit
growth.
Leverage ratio Basel III introduced a minimum "leverage ratio".
The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total
consolidated assets; The banks were expected to maintain a leverage ratio in excess of
3% under Basel III.
In July 2013, the US Federal Reserve Bank announced that the minimum Basel III leverage
ratio would be 6% for 8 Systemically important financial institution (SIFI) banks and 5%
for their insured bank holding companies.
Liquidity requirements Basel III introduced two required liquidity
ratios.
The "Liquidity Coverage Ratio" was supposed to require a bank to hold sufficient high-quality
liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding
Ratio was to require the available amount of stable funding to exceed the required amount
of stable funding over a one-year period of extended stress.
US Version of the Basel Liquidity Coverage Ratio Requirements
On 24 October 2013, the Federal Reserve Board of Governors approved an interagency proposal
for the U.S. version of the Basel Committee on Banking Supervision's (BCBS) Liquidity
Coverage Ratio (LCR).
The ratio would apply to certain U.S. banking organizations and other systematically important
financial institutions.
The comment period for the proposal is scheduled to close by 31 January 2014.
The U.S. LCR proposal came out significantly tougher than BCBS’s version, especially
for larger bank holding companies.
The proposal requires financial institutions and FSOC designated nonbank financial companies
to have an adequate stock of High Quality Liquid Assets (HQLA) that can be quickly liquidated
to meet liquidity needs over a short period of time.
The LCR consists of two parts: the numerator is the value of HQLA, and the denominator
consists of the total net cash outflows over a specified stress period (total expected
cash outflows minus total expected cash inflows).
The Liquidity Coverage Ratio applies to US banking operations with assets of more than
10 billion.
The proposal would require: Large Bank Holding Companies (BHC) – those
with over $250 billion in consolidated assets, or more in on-balance sheet foreign exposure,
and to systemically important, non-bank financial institutions; to hold enough HQLA to cover
30 days of net cash outflow.
That amount would be determined based on the peak cumulative amount within the 30 day period.
Regional firms (those with between $50 and $250 billion in assets) would be subject to
a “modified” LCR at the (BHC) level only.
The modified LCR requires the regional firms to hold enough HQLA to cover 21 days of net
cash outflow.
The net cash outflow parameters are 70% of those applicable to the larger institutions
and do not include the requirement to calculate the peak cumulative outflows
Smaller BHCs, those under $50 billion, would remain subject to the prevailing qualitative
supervisory framework.
The US proposal divides qualifying High Quality Liquid Assets into three specific categories
(Level 1, Level 2A, and Level 2B).
Across the categories the combination of Level 2A and 2B assets cannot exceed 40% HQLA with
2B assets limited to a maximum of 15% of HQLA.
Level 1 represents assets that are highly liquid (generally those risk-weighted at 0%
under the Basel III standardized approach for capital) and receive no haircut.
Notably, the Fed chose not to include GSE-issued securities in Level 1, despite industry lobbying,
on the basis that they are not guaranteed by the full faith and credit of the US government.
Level 2A assets generally include assets that would be subject to a 20% risk-weighting under
Basel III and includes assets such as GSE-issued and -guaranteed securities.
These assets would be subject to a 15% haircut which is similar to the treatment of such
securities under the BCBS version.
Level 2B assets include corporate debt and equity securities and are subject to a 50%
haircut.
The BCBS and US version treats equities in a similar manner, but corporate debt under
the BCBS version is split between 2A and 2B based on public credit ratings, unlike the
US proposal.
This treatment of corporate debt securities is the direct impact of DFA’s Section 939
(i.e., the removal of references to credit ratings) and further evidences the conservative
bias of US regulators’ approach to the LCR.
The proposal requires that the LCR be at least equal to or greater than 1.0 and includes
a multiyear transition period that would require: 80% compliance starting 1 January 2015, 90%
compliance starting 1 January 2016, and 100% compliance starting 1 January 2017.
Lastly, the proposal requires both sets of firms (large bank holding companies and regional
firms) subject to the LCR requirements to submit remediation plans to U.S. regulators
to address what actions would be taken if the LCR falls below 100% for three consecutive
days or longer.
Implementation Summary of originally (2010) proposed changes
in Basel Committee language First, the quality, consistency, and transparency
of the capital base will be raised.
Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained
earnings Tier 2 capital: supplementary capital, however,
the instruments will be harmonised Tier 3 capital will be eliminated.
Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained
earnings Tier 2 capital: supplementary capital, however,
the instruments will be harmonised Tier 3 capital will be eliminated.
Second, the risk coverage of the capital framework will be strengthened.
Promote more integrated management of market and counterparty credit risk
Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit
rating Strengthen the capital requirements for counterparty
credit exposures arising from banks' derivatives, repo and securities financing transactions
Raise the capital buffers backing these exposures Reduce procyclicality and
Provide additional incentives to move OTC derivative contracts to qualifying central
counterparties (probably clearing houses).
Currently, the BCBS has stated derivatives cleared with a QCCP will be risk-weighted
at 2% (The rule is still yet to be finalized in the U.S.)
Provide incentives to strengthen the risk management of counterparty credit exposures
Raise counterparty credit risk management standards by including wrong-way risk
Promote more integrated management of market and counterparty credit risk
Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit
rating Strengthen the capital requirements for counterparty
credit exposures arising from banks' derivatives, repo and securities financing transactions
Raise the capital buffers backing these exposures Reduce procyclicality and
Provide additional incentives to move OTC derivative contracts to qualifying central
counterparties (probably clearing houses).
Currently, the BCBS has stated derivatives cleared with a QCCP will be risk-weighted
at 2% (The rule is still yet to be finalized in the U.S.)
Provide incentives to strengthen the risk management of counterparty credit exposures
Raise counterparty credit risk management standards by including wrong-way risk
Third, a leverage ratio will be introduced as a supplementary measure to the Basel II
risk-based framework,
intended to achieve the following objectives:
Put a floor under the build-up of leverage in the banking sector
Introduce additional safeguards against model risk and measurement error by supplementing
the risk based measure with a simpler measure that is based on gross exposures.
intended to achieve the following objectives:
Put a floor under the build-up of leverage in the banking sector
Introduce additional safeguards against model risk and measurement error by supplementing
the risk based measure with a simpler measure that is based on gross exposures.
Put a floor under the build-up of leverage in the banking sector
Introduce additional safeguards against model risk and measurement error by supplementing
the risk based measure with a simpler measure that is based on gross exposures.
Fourth, a series of measures is introduced to promote the build up of capital buffers
in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting
countercyclical buffers").
Measures to address procyclicality:
Dampen excess cyclicality of the minimum capital requirement;
Promote more forward looking provisions; Conserve capital to build buffers at individual
banks and the banking sector that can be used in stress; and
Achieve the broader macroprudential goal of protecting the banking sector from periods
of excess credit growth.
Requirement to use long term data horizons to estimate probabilities of default,
downturn loss-given-default estimates, recommended in Basel II, to become mandatory
Improved calibration of the risk functions, which convert loss estimates into regulatory
capital requirements.
Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.
Promoting stronger provisioning practices (forward looking provisioning):
Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,
EL amount := LGD*PD*EAD).
Measures to address procyclicality:
Dampen excess cyclicality of the minimum capital requirement;
Promote more forward looking provisions; Conserve capital to build buffers at individual
banks and the banking sector that can be used in stress; and
Dampen excess cyclicality of the minimum capital requirement;
Promote more forward looking provisions; Conserve capital to build buffers at individual
banks and the banking sector that can be used in stress; and
Achieve the broader macroprudential goal of protecting the banking sector from periods
of excess credit growth.
Requirement to use long term data horizons to estimate probabilities of default,
downturn loss-given-default estimates, recommended in Basel II, to become mandatory
Improved calibration of the risk functions, which convert loss estimates into regulatory
capital requirements.
Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.
Requirement to use long term data horizons to estimate probabilities of default,
downturn loss-given-default estimates, recommended in Basel II, to become mandatory
Improved calibration of the risk functions, which convert loss estimates into regulatory
capital requirements.
Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.
Promoting stronger provisioning practices (forward looking provisioning):
Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,
EL amount := LGD*PD*EAD).
Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,
EL amount := LGD*PD*EAD).
Fifth,a global minimum liquidity standard for internationally active banks is introduced
that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term
structural liquidity ratio called the Net Stable Funding Ratio.
(In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued
a statement saying that regulators will allow banks to dip below their required liquidity
levels, the liquidity coverage ratio, during periods of stress.)
The Committee also is reviewing the need for additional capital, liquidity or other supervisory
measures to reduce the externalities created by systemically important institutions.
As of September 2010, proposed Basel III norms asked for ratios as: 7–9.5% (4.5% + 2.5%
(conservation buffer) + 0–2.5% (seasonal buffer)) for common equity and 8.5–11% for
Tier 1 capital and 10.5–13% for total capital.
On 15 April, the Basel Committee on Banking Supervision (“BCBS”) released the final
version of its “Supervisory Framework for Measuring and Controlling Large Exposures”
(“SFLE”) that builds upon longstanding BCBS guidance on credit exposure concentrations.
U.S. implementation The U.S. Federal Reserve announced in December
2011 that it would implement substantially all of the Basel III rules.
It summarized them as follows, and made clear they would apply not only to banks but also
to all institutions with more than US$50 billion in assets:
"Risk-based capital and leverage requirements" including first annual capital plans, conduct
stress tests, and capital adequacy "including a tier one common risk-based capital ratio
greater than 5 percent, under both expected and stressed conditions" – see scenario
analysis on this.
A risk-based capital surcharge Market liquidity, first based on the US's
own "interagency liquidity risk-management guidance issued in March 2010" that require
liquidity stress tests and set internal quantitative limits, later moving to a full Basel III regime
- see below.
The Federal Reserve Board itself would conduct tests annually "using three economic and financial
market scenarios."
Institutions would be encouraged to use at least five scenarios reflecting improbable
events, and especially those considered impossible by management, but no standards apply yet
to extreme scenarios.
Only a summary of the three official Fed scenarios "including company-specific information, would
be made public" but one or more internal company-run stress tests must be run each year with summaries
published.
Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a
single counterparty as a percentage of the firm's regulatory capital.
Credit exposure between the largest financial companies would be subject to a tighter limit."
"Early remediation requirements" to ensure that "financial weaknesses are addressed at
an early stage".
One or more "triggers for remediation—such as capital levels, stress test results, and
risk-management weaknesses—in some cases calibrated to be forward-looking" would be
proposed by the Board in 2012.
"Required actions would vary based on the severity of the situation, but could include
restrictions on growth, capital distributions, and executive compensation, as well as capital
raising or asset sales."
As of January 2014, the U.S. has been on track to implement many of the Basel III rules,
however differences remain in ratio requirements and calculations.
Key milestones Liquidity requirements
Analysis on Basel III impact Macroeconomic impact
An OECD study released on 17 February 2011, estimated that the medium-term impact of Basel
III implementation on GDP growth would be in the range of −0.05% to −0.15% per year.
Economic output would be mainly affected by an increase in bank lending spreads, as banks
pass a rise in bank funding costs, due to higher capital requirements, to their customers.
To meet the capital requirements originally effective in 2015 banks were estimated to
increase their lending spreads on average by about 15 basis points.
Capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for
the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points.
The estimated effects on GDP growth assume no active response from monetary policy.
To the extent that monetary policy would no longer be constrained by the zero lower bound,
the Basel III impact on economic output could be offset by a reduction (or delayed increase)
in monetary policy rates by about 30 to 80 basis points.
Critics Think-tanks such as the World Pensions Council
(WPC) have argued that Basel III merely builds on and further expands the existing Basel
II regulatory base, without questioning fundamentally its core tenets, notably the ever-growing
reliance on standardized assessments of "credit risk" marketed by two private sector agencies-
Moody's and S&P, thus using public policy to strengthen anti-competitive duopolistic
practices.
Basel III has also been criticized by banks, organized in the Institute of International
Finance in Washington D.C. (an international association of global banks) with the argument
that it would hurt them and economic growth.
OECD estimated that implementation of Basel III would decrease annual GDP growth by 0.05–0.15%,
blaming regulation as responsible for slow recovery from the late-2000s financial crisis.
Basel III was also criticized as negatively affecting the stability of the financial system
by increasing incentives of banks to game the regulatory framework.
The American Banker's Association, community banks organized in the Independent Community
Bankers of America, and some of the most liberal Democrats in the U.S. Congress, including
the entire Maryland congressional delegation with Democratic Sens. Cardin and Mikulski
and Reps. Van Hollen and Cummings, voiced opposition to Basel III in their comments
submitted to FDIC, saying that the Basel III proposals, if implemented, would hurt small
banks by increasing "their capital holdings dramatically on mortgage and small business
loans."
Others have argued that Basel III did not go far enough to regulate banks as inadequate
regulation was a cause of the financial crisis.
On 6 January 2013 the global banking sector won a significant easing of Basel III Rules,
when the Basel Committee on Banking Supervision extended not only the implementation schedule
to 2019, but broadened the definition of liquid assets.
Further studies In addition to articles used for references
(see References), this section lists links to recent high-quality publicly available
studies on Basel III.
This section may be updated frequently as Basel III is still under development.