Basel III

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Basel III (or the Third Basel Accord) 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 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 late-2000s financial crisis. Basel III was supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.

General Overview[edit]

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[edit]

Capital requirements[edit]

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 (including common equity and up from 4% in Basel II) of "risk-weighted assets" (RWA).[3] Basel III introduced "additional 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[edit]

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;[4] 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.[5]

Liquidity requirements[edit]

Basel III introduced two required liquidity ratios.[6] 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.[7]

US Version of the Basel Liquidity Coverage Ratio Requirements[edit]

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.[8] 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.[9] The proposal requires financial institutions and FSOC designated nonbank financial companies[10] 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).[11]

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;[10] 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.[8]
  • 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[11]
  • Smaller BHCs, those under $50 billion, would remain subject to the prevailing qualitative supervisory framework.[12]

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.[11]

  • 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.[13]

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[edit]

Summary of originally (2010) proposed changes in Basel Committee language[edit]

  • 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.[14]
  • Second, the risk coverage of the capital framework will be strengthened.
  • 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.
  • 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).[15]
  • 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.[16])
  • 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.[17]

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. [18]

U.S. implementation[edit]

The U.S. Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules.[19] 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."[20]

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.[21]

Key milestones[edit]

Capital requirements[edit]

Date Milestone: Capital Requirement
2014 Minimum capital requirements: Start of the gradual phasing-in of the higher minimum capital requirements.
2015 Minimum capital requirements: Higher minimum capital requirements are fully implemented.
2016 Conservation buffer: Start of the gradual phasing-in of the conservation buffer.
2019 Conservation buffer: The conservation buffer is fully implemented.

Leverage ratio[edit]

Date Milestone: Leverage Ratio
2011 Supervisory monitoring: Developing templates to track the leverage ratio and the underlying components.
2013 Parallel run I: The leverage ratio and its components will be tracked by supervisors but not disclosed and not mandatory.
2015 Parallel run II: The leverage ratio and its components will be tracked and disclosed but not mandatory.
2017 Final adjustments: Based on the results of the parallel run period, any final adjustments to the leverage ratio.
2018 Mandatory requirement: The leverage ratio will become a mandatory part of Basel III requirements.

Liquidity requirements[edit]

Date Milestone: Liquidity Requirements
2011 Observation period: Developing templates and supervisory monitoring of the liquidity ratios.
2015 Introduction of the LCR: Initial introduction of the Liquidity Coverage Ratio (LCR), with a requirement of 60%. This will increase by ten percentage points each year until 2019.
2018 Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR).
2019 LCR comes into full effect: Liquidity Coverage Ratio of 100% is expected of firms.

Analysis on Basel III impact[edit]

Macroeconomic impact[edit]

An OECD study[22] 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.[23] 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.[22]

Critics[edit]

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.[24][25]

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%,[22][26] blaming regulation as responsible for slow recovery from the late-2000s financial crisis.[27][28] Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework.[29] The American Banker's Association,[30] 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,[31] saying that the Basel III proposals, if implemented, would hurt small banks by increasing "their capital holdings dramatically on mortgage and small business loans."[32] Others have argued that Basel III did not go far enough to regulate banks as inadequate regulation was a cause of the financial crisis.[33] 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.[34]

Further studies[edit]

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.

Date Source Article Title / Link Comments
Feb 2012 BNP Paribas Fortis Basel III for dummies
Video
"All you need to know about Basel III in 10 minutes." Updated for 6 January 2013 decisions.
Dec 2011 OECD: Economics Department Systemically Important Banks OECD analysis on the failure of bank regulation and markets to discipline systemically important banks.
Jun 2011 BNP Paribas: Economic Research Department Basel III: no Achilles' spear BNP Paribas' Economic Research Department study on Basel III.
Feb 2011 Georg, co-Pierre Basel III and Systemic Risk Regulation – What Way Forward? An overview article of Basel III with a focus on how to regulate systemic risk.
Feb 2011 OECD: Economics Department Macroeconomic Impact of Basel III OECD analysis on the macroeconomic impact of Basel III.
May 2010 OECD Journal:
Financial Market Trends
Thinking Beyond Basel III OECD study on Basel I, Basel II and III.
May 2010 Bloomberg
BusinessWeek
FDIC's Bair Says Europe Should Make Banks Hold More Capital Bair said regulators around the world need to work together on the next round of capital standards for banks ... the next round of international standards, known as Basel III, which Bair said must meet "very aggressive" goals.
May 2010 Reuters FACTBOX-G20 progress on financial regulation Finance ministers from the G20 group of industrial and emerging countries meet in Busan, Korea, on 4–5 June to review pledges made in 2009 to strengthen regulation and learn lessons from the financial crisis.
May 2010 The Economist The banks battle back
A behind-the-scenes brawl over new capital and liquidity rules
"The most important bit of reform is the international set of rules known as "Basel 3", which will govern the capital and liquidity buffers banks carry. It is here that the most vicious and least public skirmish between banks and their regulators is taking place."

See also[edit]

References[edit]

  1. ^ "Group of Governors and Heads of Supervision announces higher global minimum capital standards" (pdf). Basel Committee on Banking Supervision. 12 September 2010. 
  2. ^ Financial Times report Oct 2012
  3. ^ http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf
  4. ^ http://www.investopedia.com/terms/t/tier-1-leverage-ratio.asp#axzz2FJchzgOy
  5. ^ "US Federal Reserve Bank announces the minimum Basel III leverage ratio". [dead link]
  6. ^ http://www.bis.org/publ/bcbs189.pdf
  7. ^ Hal S. Scott (16 June 2011). "Testimony of Hal S. Scott before the Committee on Financial Services" (pdf). Committee on Financial Services, United State House of Representatives. pp. 12–13. Retrieved 17 November 2012. 
  8. ^ a b http://www.federalreserve.gov/FR_notice_lcr_20131024.pdf
  9. ^ "Fed Liquidity Proposal Seen Trading Safety for Costlier Credit". Bloomberg. 
  10. ^ a b "Nonbank SIFIs: FSOC proposes initial designations more names to follow". http://www.pwc.com/en_US/us/financial-services/regulatory-services/publications/assets/fs-reg-brief-nonbank-sifi.pdf, June 2013. 
  11. ^ a b c "Liquidity coverage ratio: another brick in the wall". http://www.pwc.com/en_US/us/financial-services/regulatory-services/publications/assets/fs-reg-brief-dodd-frank-act-basel-iii-fed-liquidity-coverage-ratio.pdf, October 2013. 
  12. ^ http://www.federalreserve.gov/newsevents/press/bcreg/20131024a.htm
  13. ^ http://www.ft.com/cms/s/0/9f61345c-3cb1-11e3-a8c4-00144feab7de.html#axzz2jWZZfSmH
  14. ^ "Strengthening the resilience of the banking sector" (pdf). BCBS. December 2009. p. 15. "Tier 3 will be abolished to ensure that market risks are met with the same quality of capital as credit and operational risks." 
  15. ^ "Basel II Comprehensive version part 2: The First Pillar – Minimum Capital Requirements" (pdf). November 2005. p. 86. 
  16. ^ Susanne Craig (8 January 2012). "Bank Regulators to Allow Leeway on Liquidity Rule". New York Times. Retrieved 10 January 2012. 
  17. ^ Proposed Basel III Guidelines: A Credit Positive for Indian Banks
  18. ^ "Stress testing: First take: Basel large exposures framework". http://www.pwc.com/us/en/financial-services/regulatory-services/publications/index.jhtml. PwC Financial Services Regulatory Practice, April 2014. 
  19. ^ Edward Wyatt (20 December 2011). "Fed Proposes New Capital Rules for Banks". New York Times. Retrieved 6 July 2012. 
  20. ^ "Press Release". Federal Reserve Bank. 20 December 2011. Retrieved 6 July 2012. 
  21. ^ "Basel leverage ratio: No cover for US banks". http://www.pwc.com/us/en/financial-services/regulatory-services/publications/dodd-frank-basel-leverage-ratio.jhtml. PwC Financial Services Regulatory Practice, January 2014. 
  22. ^ a b c Patrick Slovik; Boris Cournède (2011). Macroeconomic Impact of Basel III. OECD Economics Department Working Papers. OECD Publishing. doi:10.1787/5kghwnhkkjs8-en. 
  23. ^ ?
  24. ^ M. Nicolas J. Firzli, "A Critique of the Basel Committee on Banking Supervision" Revue Analyse Financière, 10 November 2011 & Q2 2012
  25. ^ Barr, David G. (23 November 2013). "What We Thought We Knew: The Financial System and Its Vulnerabilities" (pdf). Bank of England. 
  26. ^ Jones, Huw (September 2010). "Basel rules to have little impact on economy" (pdf). Reuters. 
  27. ^ John Taylor (September 2012). "Regulatory Expansion Versus Economic Expansion in Two Recoveries". 
  28. ^ Philip Suttle (3 March 2011). "The Macroeconomic Implications of Basel III". Institute of International Finance. Retrieved 17 November 2012. 
  29. ^ Patrick Slovik (2012). Systemically Important Banks and Capital Regulations Challenges. OECD Economics Department Working Papers. OECD Publishing. doi:10.1787/5kg0ps8cq8q6-en. 
  30. ^ Comment Letter on Proposals to Comprehensively Revise the Regulatory Capital Framework for U.S.Banking Organizations(22 October 2012, http://www.sifma.org/workarea/downloadasset.aspx?id=8589940758
  31. ^ 95 entities listed at http://www.fdic.gov/regulations/laws/federal/2012-ad-95-96-97/2012-ad95.html Retrieved 13 March 2013
  32. ^ http://www.icba.org/files/ICBASites/PDFs/test112912.pdf
  33. ^ Reich, Robert. "Wall Street is Still Out of Control, and Why Obama Should Call for Glass-Steagall and a Breakup of Big Banks". Robert Reich.org. Retrieved 2 March 2013. 
  34. ^ NY Times 1 July 2013 http://dealbook.nytimes.com/2013/01/07/easing-of-rules-for-banks-acknowledges-reality/

External links[edit]