Basel III – An Overview of the New Global Regulatory Standard
The financial crisis of 2007-2010 made it clear to global financial regulators that banks had to have bigger capital reserves in order to withstand future economic downturns. This led to the formulation of Basel III in September 2010, a new global regulatory standard for the banking industry.
The standard, developed by the Basel Committee on Banking Supervision, aim to “strengthen the regulation, supervision and risk management of the banking sector.” The regulators expect these new measures to:
- Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source
- Improve risk management and governance
- Strengthen banks' transparency and disclosures.
The reforms take two approaches to supervision that are complementary, increasing resilience at the individual bank level to reduce the risk of system-wide shocks:
- bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.
- macroprudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.
Summary of requirements
The new rule prescribes how to assess risks, and how much capital to set aside for banks in keeping with their risk profile. The Basel III framework is divided into two three pillars:
- Pillar 1: Capital, Risk coverage, Containing leverage
- Pillar 2: Risk management and supervision
- Pillar 3: Market discipline
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Capital requirements:
According to the Financial Times, Basel III capital requirements include:
"... a new key capital ratio of 4.5 per cent, which is twice the current 2 per cent requirement. Banks also need to adhere to a new buffer of a further 2.5 per cent. Banks whose capital falls within the buffer zone will face restrictions on paying dividends and discretionary bonuses, so the rule sets an effective floor of 7 per cent. The new rules will be phased in from January 2013 through to January 2019.
Banks will be required to triple core tier one capital ratios from 2 per cent to 7 per cent by 2019. This ratio measures the buffer of highest quality capital that banks hold against future losses."
Risk coverage
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Securitizations
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The new rules:
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Trading book
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Counterparty credit risk
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The new rule substantially strengthens the counterparty credit risk framework by including:
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Containing leverage
The new rule requires a non-risk-based leverage ratio that includes off-balance sheet exposures will serve as a backstop to the risk-based capital requirements. This will help contain the system-wide build up of leverage.
Risk management and supervision
These new requirements:
- Address firm-wide governance and risk management
- Capturing the risk of off-balance sheet exposures and securitization activities
- Managing risk concentrations
- Providing incentives for banks to better manage risk and returns over the long term
- Sound compensation practices
- Valuation practices
- Stress testing
- Accounting standards for financial instruments
- Corporate governance and
- Supervisory colleges
Market discipline
Market discipline is reinforced in the new rule with enhanced disclosure requirements. These include:
- Disclosures related to securitization exposures and sponsorship of offbalance sheet vehicles.
- Disclosures detailing the components of regulatory capital and their reconciliation to the reported accounts, including a comprehensive explanation of how a bank calculates its regulatory capital ratios.
Liquidity requirements
Liquidity coverage ratio
The liquidity coverage ratio (LCR) will require banks to have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario that is specified by supervisors.
Net stable funding ratio
The net stable funding ratio (NSFR) is a longer-term structural ratio designed to address liquidity mismatches. It covers the entire balance sheet and provides incentives for banks to use stable sources of funding.
Principles for Sound Liquidity
- Risk Management and Supervision: The Committee's 2008 guidanceentitled Principles takes account oflessons learned during the crisis andare based on a fundamental reviewof sound practices for managingliquidity risk in bankingorganizations.
- Supervisory monitoring: The liquidity framework includes acommon set of monitoring metricsto assist supervisors in identifyingand analyzing liquidity risk trends atboth the bank and system-wide level.
Impact of Basel III
In February 2011, the OECD’s Economics Department did a study on the potential macroeconomic impact of the Basel III regulations and found that:
- The estimated 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.
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