Basel III

Basel III (or the Third Basel Accord) is a global, voluntary regulatory framework 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 and again extended to 31 March 2019.^[1][2] The third installment of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. Basel III is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.

Overview

Unlike Basel I and Basel II, which focus primarily on the level of bank loss reserves that banks are required to hold, Basel III focuses primarily on the risk of a run on the bank, requiring differing levels of reserves for different forms of bank deposits and other borrowings. Therefore, Basel III does not, for the most part, supersede the guidelines known as Basel I and Basel II; rather, it will work alongside them.

Key principles

Capital requirements

The original Basel III rule from 2010 required banks to fund themselves with 4.5% of common equity (up from 2% in Basel II) of risk-weighted assets (RWAs). Since 2015, a minimum Common Equity Tier 1 (CET1) ratio of 4.5% must be maintained at all times by the bank.^[3] This ratio is calculated as follows:

The minimum Tier 1 capital increases from 4% in Basel II to 6%,^[3] applicable in 2015, over RWAs.^[4] This 6% is composed of 4.5% of CET1, plus an extra 1.5% of Additional Tier 1 (AT1).

Furthermore, Basel III introduced two additional capital buffers:

• A mandatory "capital conservation buffer", equivalent to 2.5% of risk-weighted assets. Considering the 4.5% CET1 capital ratio required, banks have to hold a total of 7% CET1 capital, from 2019 onwards.
• A "discretionary counter-cyclical buffer", allowing national regulators to require up to an additional 2.5% of capital during periods of high credit growth. The level of this buffer ranges between 0% and 2.5% of RWA and must be met by CET1 capital.

Leverage ratio

Basel III introduced a minimum "leverage ratio". This is a non-risk-based leverage ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items).^[5][6] The banks are expected to maintain a leverage ratio in excess of 3% under Basel III.

In July 2013, the U.S. Federal Reserve 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.^[7]

Liquidity requirements

Basel III introduced two required liquidity ratios.^[8]

• 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. Mathematically it is expressed as follows:

• 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.^[9]

U.S. 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 (BCBS)'s Liquidity Coverage Ratio (LCR). The ratio would apply to certain U.S. banking organizations and other systemically important financial institutions.^[10] The comment period for the proposal closed on 31 January 2014.

The United States' LCR proposal came out significantly tougher than BCBS’s version, especially for larger bank holding companies.^[11] The proposal requires financial institutions and FSOC designated nonbank financial companies^[12] 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).^[13]

The Liquidity Coverage Ratio applies to U.S. 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;^[12] 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.^[10]
• 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^[13]
• Smaller BHCs, those under $50 billion, would remain subject to the prevailing qualitative supervisory framework.^[14]

The U.S. proposal divides qualifying HQLAs 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.^[13]

• 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 U.S. 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 U.S. 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 U.S. proposal. This treatment of corporate debt securities is the direct impact of the Dodd–Frank Act's Section 939, which removed references to credit ratings, and further evidences the conservative bias of U.S. 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.^[15]

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 or more consecutive days.

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.^[16]
• Second, the risk coverage of the capital framework will be strengthened.
  • Promote more integrated management of market and counterparty credit risk
  • Add the 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 buildup 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 buildup 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).^[17]
• 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.^[18])
• 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.^[19]

On April 15, 2014, the Basel Committee on Banking Supervision (BCBS) released the final version of its "Supervisory Framework for Measuring and Controlling Large Exposures" (SFLE) that builds on longstanding BCBS guidance on credit exposure concentrations.^[20]

On 3 September 2014, the U.S. banking agencies (Federal Reserve, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation) issued their final rule implementing the Liquidity Coverage Ratio (LCR).^[21] The LCR is a short-term liquidity measure intended to ensure that banking organizations maintain a sufficient pool of liquid assets to cover net cash outflows over a 30-day stress period.

On March 11, 2016, the Basel Committee on Banking Supervision released the second of three proposals on public disclosure of regulatory metrics and qualitative data by banking institutions. The proposal requires disclosures on market risk to be more granular for both the standardized approach and regulatory approval of internal models.^[22]

U.S. implementation

The U.S. Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules.^[23] 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 United States' 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".^[24]

As of January 2014, the United States has been on track to implement many of the Basel III rules, despite differences in ratio requirements and calculations.^[25]

Europe implementation

The implementing act of the Basel III agreements in the European Union has been the new legislative package comprising Directive 2013/36/EU (CRD IV) and Regulation (EU) No. 575/2013 on prudential requirements for credit institutions and investment firms (CRR).^[26]

The new package, approved in 2013, replaced the Capital Requirements Directives (2006/48 and 2006/49).^[27]

Key milestones

Capital requirements

Leverage ratio

Liquidity requirements

Analysis of Basel III impact

In the United States higher capital requirements resulted in contractions in trading operations and the number of personnel employed on trading floors.^[29]

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.^[30] 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.^[31] 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.^[30]

Criticism

Think tanks such as the World Pensions Council have argued that Basel III merely builds on and further expands the existing Basel II regulatory base without fundamentally questioning 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.^[32][33] The conflicted and unreliable credit ratings of these agencies is generally seen as a major contributor to the US housing bubble.

Opaque treatment of all derivatives contracts is also criticized. While institutions have many legitimate ("hedging", "insurance") risk reduction reasons to deal in derivatives, the Basel III accords:

• treat insurance buyers and sellers equally even though sellers take on more concentrated risks (literally purchasing them) which they are then expected to offset correctly without regulation
• do not require organizations to investigate correlations of all internal risks they own
• do not tax or charge institutions for the systematic or aggressive externalization or conflicted marketing of risk - other than requiring an orderly unravelling of derivatives in a crisis and stricter record keeping

Since derivatives present major unknowns in a crisis these are seen as major failings by some critics ^[34] causing several to claim that the "too big to fail" status remains with respect to major derivatives dealers who aggressively took on risk of an event they did not believe would happen - but did. As Basel III does not absolutely require extreme scenarios that management flatly rejects to be included in stress testing this remains a vulnerability. Standardized external auditing and modelling is an issue proposed to be addressed in Basel 4 however.

A few critics argue that capitalization regulation is inherently fruitless due to these and similar problems and - despite an opposite ideological view of regulation - agree that "too big to fail" persists.^[35]

Basel III has been criticized similarly for its paper burden and risk inhibition by banks, organized in the Institute of International Finance, an international association of global banks based in Washington, D.C., who argue that it would "hurt" both their business and overall economic growth. Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework.^[36] The American Bankers Association,^[37] 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 Senators Ben Cardin and Barbara Mikulski and Representatives Chris Van Hollen and Elijah Cummings, voiced opposition to Basel III in their comments to the Federal Deposit Insurance Corporation,^[38] saying that the Basel III proposals, if implemented, would hurt small banks by increasing "their capital holdings dramatically on mortgage and small business loans".^[39]

Others have argued that Basel III did not go far enough to regulate banks as inadequate regulation was a cause of the financial crisis.^[40] However, these arguments should be examined closely, as Basel III was not in effect until after the financial crisis occurred. 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.^[41]

Further studies

In addition to articles used for references (see References), this section lists links to publicly available high-quality studies on Basel III. This section may be updated frequently as Basel III remains under development.

See also

• Basel I
• Basel II
• Basel 4
• Systemically important financial institution
• Operational risk
• Operational risk management

References

External links

• Basel III capital rules
• Basel III liquidity rules
• Bank Management and Control, Springer – Management for Professionals, 2014
• U.S. Implementation of the Basel Capital Regulatory Framework Congressional Research Service
• - Basel III in India
• How Basel III Affects SME Borrowing Capacity