BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed upon by the members of the Basel Committee on Banking Supervision

Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance...

. The third of the Basel Accords was developed in a response to the deficiencies in financial regulation revealed by the global financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.

Overview

Basel III will 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 also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Summary of proposed changes

• First, the quality, consistency, and transparency of the capital base will be raised.
  • Tier 1 capital
    Tier 1 capital
    Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves , but may also include non-redeemable non-cumulative preferred stock...
    
    : the predominant form of Tier 1 capital must be common shares and retained earnings
  • Tier 2 capital
    Tier 2 capital
    Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
    
     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
    Clearing house (finance)
    A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
    
    )
  • Provide incentives to strengthen the risk management of counterparty credit exposures
  • Raise counterparty credit risk management standards by including wrong-way risk
• Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework.
  • The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives:
    • Put a floor under the build-up of leverage
      Leverage (finance)
      In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
      
       in the banking sector
    • Introduce additional safeguards against model risk
      Model risk
      In finance, model risk is the risk involved in using models to value financial securities. Rebonato considers alternative definitions including:...
      
       and measurement error
      Sampling error
      -Random sampling:In statistics, sampling error or estimation error is the error caused by observing a sample instead of the whole population. The sampling error can be found by subtracting the value of a parameter from the value of a statistic...
      
       by supplementing the risk based measure with a simpler measure that is based on gross exposures.
• Fourth, the Committee is introducing a series of measures 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").
  • The Committee is introducing a series of measures to address procyclicality:
    • Dampen any 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
      Credit spread (bond)
      The financial term, credit spread is the yield spread, or difference in yield between different securities, due to different credit quality. The credit spread reflects the additional net yield an investor can earn from a security with more credit risk relative to one with less credit risk...
      
       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
      Probability of default
      Probability of default is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. This is an attribute of a bank's client.-Definition:...
      
      *EAD).
• Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio
  Net Stable Funding Ratio
  During the 2007 banking crisis, banks such as Northern Rock in the UK, and US investment banks such as Bear Stearns and Lehman Brothers suffered a bank run and/or collapsed, due to their over-reliance on short term wholesale funding from the Interbank lending market and lack of capital.As a result...
  
  .
• The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important
  Systemic risk
  In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
  
   institutions.

As on Sept 2010, Proposed Basel III norms ask 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 cap and 10.5 to 13 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)'

Macroeconomic Impact of Basel III

An OECD study released on 17 February 2011, estimates that the medium-term impact of Basel III implementation on GDP growth is in the range of −0.05 to −0.15 percentage point per annum. Economic output is 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 effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The 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 will 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.

Basel III is an opportunity as well as a challenge for banks. It can provide a solid foundation for the next developments in the banking sector, and it can ensure that past excesses are avoided. Basel III is changing the way that banks address the management of risk and finance. The new regime seeks much greater integration of the finance and risk management functions. This will probably drive the convergence of the responsibilities of CFOs and CROs in delivering the strategic objectives of the business. However, the adoption of a more rigorous regulatory stance might be hampered by a reliance on multiple data silos and by a separation of powers between those
who are responsible for finance and those who manage risk. The new emphasis on risk management that is inherent in Basel III requires the introduction or evolution of a risk management framework that is as robust as the existing finance management infrastructures. As well as being a regulatory regime, Basel III in many ways provides a framework for true enterprise risk management, which involves covering all risks to the business.

Capital Requirements

Date	Milestone: Capital Requirements
2013	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: Introduction of the Liquidity Coverage Ratio (LCR).
2018	Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR).

In the news

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 currently under development.

Date	Source	Article Title / Link	Comments
Jun 2011	BNP Paribas: Economic Research Department	Basel III: no Achilles' spear	BNP Paribas' Economic Research Department study on Basel III.
Feb 2011	OECD: Economics Department	Macroeconomic Impact of Basel III	OECD analysis on the macroeconomic impact of Basel III.
Jan 2011	Moody's Analytics Moody's Analytics Moody’s Analytics provides capital markets and risk management professionals with credit analysis, economic research, financial risk management software, and advisory services...	Basel III New Capital and Liquidity Standards FAQs	Basel III standards, key elements of new regulations, framework, and key implementation dates.
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."
May 2010	Reuters	G20 ministers face more wrangling over bank tax	"Bank capital is like a train in a dark tunnel -- nobody can see it and when it does come out, it does not capture the public's imagination,"

See also

• Basel I
  Basel I
  Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten countries...
  
  
• Basel II
  Basel II
  Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision...
  
  
• Capital adequacy
• Financial crisis of 2007–2010
• G-20
• Operational risk
  Operational risk
  An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
  
  
• Operational risk management
  Operational risk management
  The term Operational Risk Management is defined as a continual cyclic process which includes risk assessment, risk decision making, and implementation of risk controls, which results in acceptance, mitigation, or avoidance of risk...
  
  
• Global systemically important banks
  Global systemically important banks
  Global systemically important banks is a set of banks defined by the Basel Committee as banks whose failure could trigger a global financial crisis. In order to offset the systemic risk due to these institutions, the Basel Committee has laid out macroprudential regulations aiming reducing the...
  
  

External links

• Basel III capital rules
• Basel III liquidity rules