Basel III

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; changes from January 7, 2013 extended implementation until 2019 however. 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 bank leverage.

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 "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

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 the leverage ratio in excess of 3%.

Liquidity requirments

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.

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 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 central counterparties (probably clearing houses)
  • 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.
• 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).
• 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.

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 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."

It was unclear as of December 2011 how these rules would apply to insurance, hedge funds and other large financial players. The announced intent was "to limit the dangers of big financial firms being heavily intertwined."

Key milestones

Capital Requirements

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

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

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

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

Basel III has been criticized by banks, organized in the Institute of International Finance in Washington D.C. (large American and European banks, including Goldman Sachs, Morgan Stanley, Deutsche Bank) with the argument 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 January 6, 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.

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 Jan 06 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 June 4–5 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

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

External links

• Basel III capital rules
• Basel III liquidity rules
• U.S. Implementation of the Basel Capital Regulatory Framework Congressional Research Service.
• Basel III in India