Understanding Basel III
Basel III is an internationally agreed regulatory framework developed by the Basel Committee on Banking Supervision (BCBS) in response to the 2007-09 financial crisis. Its main aim is to enhance regulation, supervision, and risk management in the banking industry and address weaknesses in the financial system to prevent future crises.
Basel III builds on earlier Basel I and II accords and continues the efforts to improve banking regulation and prevent banks from taking excessive risks that could disrupt the economy. All three accords namely Basel I, II, and III developed by the Basel Committee on Banking Supervision (BCBS) was created in 1974 by central bank governors from Group of Ten (G10) countries to address financial market disruptions and serve as a forum for discussions and improving banking regulations.
Key Principles of Basel III
Minimum Capital Requirements:
- Basel III raised the minimum capital requirement for banks from 2% in Basel II to 4.5% of common equity, based on the bank’s risk-weighted assets.
- An additional 2.5% buffer capital is required, bringing the total minimum capital requirement to 7%. This buffer can be used during financial stress, but using it can limit the bank’s ability to pay dividends
- The Tier 1 capital requirement increased from 4% in Basel II to 6% in Basel III. This 6% includes 4.5% Common Equity Tier 1 and an additional 1.5% of Additional Tier 1 capital
- .The requirements were set to start in 2013 but have been delayed several times. Banks now have until January 1, 2022, to fully implement these changes.
Leverage Ratio:
- Basel III introduced a non-risk leverage ratio that acts as a safeguard to the risk-based capital requirements.
- Banks must hold a leverage ratio above 3%. This ratio is calculated by dividing Tier 1 capital by the average total consolidated assets of the bank.
- U.S Federal Reserve Bank fixed the leverage ratio at 5% for insuring bank holding companies and 6% for Systematically Important Financial Institutions (SIFI).
Liquidity Requirements:
- Basel III introduced usage of 2 liquidity ratios namely Liquidity Coverage Ratio and Net Stable Funding Ratio.
- Liquidity Coverage Ratio (LCR): Banks must maintain an adequate level of high-quality liquid assets (HQLA) that can cover their total net cash outflows over a 30-day stress period. Introduced in 2015, initially at 60% of the full requirement. It increases by 10% each year until it reached 100% in 2019.
- Net Stable Funding Ratio: Ensures that banks have a stable funding profile in relation to their assets and off-balance-sheet activities, promoting longer-term stability.
Impacts of Basel III
- A study conducted by Organization for Economic Cooperation and Development (OECD) in 2011 projected that Basel III could lead to a small annual reduction in GDP, between -0.05% and -0.15%. To compensate, banks might be forced to increase lending spreads, passing the additional costs onto their customers.
- Basel III’s new liquidity requirements, including the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), will impact the bond market. Banks may avoid high run-off assets like Special Purpose Vehicles (SPVs) and Structured Investment Vehicles (SIVs) to meet LCR criteria.
- To satisfy LCR requirements, banks will prefer holding government bonds and covered bonds that will reduce the demand for securitized assets and lower-quality corporate bonds. This shift will lead to banks holding more liquid assets and increasing long-term debt to align with NSFR and reduce maturity mismatches.
- Basel III’s capital requirements could lead to fewer clearing brokers in the derivatives market due to increased costs. The regulations impose higher capital charges for derivative trades with dealers compared to trades cleared through a central clearing counterparty (CCP).
