Basel III

Basel III (or the Third Basel Accord) is a global, voluntary regulatory framework 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 financial crisis of 2007–08. Basel III is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.

Overview

Unlike Basel I and Basel II, which focus primarily on the level of bank loss reserves that banks are required to hold, Basel III focuses primarily on the risk of a run on the bank, requiring differing levels of reserves for different forms of bank deposits and other borrowings. Therefore, Basel III does not, for the most part, supersede the guidelines known as Basel I and Basel II; rather, it will work alongside them.

Key principles

Capital requirements

The original Basel III rule from 2010 required banks to fund themselves with 4.5% of common equity (up from 2% in Basel II) of risk-weighted assets (RWAs). Since 2015, a minimum Common Equity Tier 1 (CET1) ratio of 4.5% must be maintained at all times by the bank.[3] This ratio is calculated as follows:

 \frac{\mbox{CET1}}{\mbox{RWAs}} \geq 4.5%

The minimum Tier 1 capital increases from 4% in Basel II to 6%,[3] applicable in 2015, over RWAs.[4] This 6% is composed of 4.5% of CET1, plus an extra 1.5% of Additional Tier 1 (AT1).

Furthermore, Basel III introduced two additional capital buffers:

Leverage ratio

Basel III introduced a minimum "leverage ratio". This is a non-risk-based leverage ratio and is calculated by dividing Tier 1 capital by the bank's average total consolidated assets (sum of the exposures of all assets and non-balance sheet items).[5][6] The banks are expected to maintain a leverage ratio in excess of 3% under Basel III.

 \frac{\mbox{Tier 1 Capital}}{\mbox{Total exposure}} \geq 3%

In July 2013, the U.S. Federal Reserve 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.[7]

Liquidity requirements

Basel III introduced two required liquidity ratios.[8]

 LCR=\frac{\mbox{High quality liquid assets}}{\mbox{Total net liquidity outflows over 30 days}} \geq 100%

U.S. version of the Basel Liquidity Coverage Ratio requirements

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 (BCBS)'s Liquidity Coverage Ratio (LCR). The ratio would apply to certain U.S. banking organizations and other systemically important financial institutions.[10] The comment period for the proposal closed on 31 January 2014.

The United States' LCR proposal came out significantly tougher than BCBS’s version, especially for larger bank holding companies.[11] The proposal requires financial institutions and FSOC designated nonbank financial companies[12] 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).[13]

The Liquidity Coverage Ratio applies to U.S. banking operations with assets of more than $10 billion. The proposal would require:

The U.S. proposal divides qualifying HQLAs 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.[13]

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.[15]

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 or more consecutive days.

Implementation

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

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.[19]

On April 15, 2014, the Basel Committee on Banking Supervision (BCBS) released the final version of its "Supervisory Framework for Measuring and Controlling Large Exposures" (SFLE) that builds on longstanding BCBS guidance on credit exposure concentrations.[20]

On 3 September 2014, the U.S. banking agencies (Federal Reserve, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation) issued their final rule implementing the Liquidity Coverage Ratio (LCR).[21] The LCR is a short-term liquidity measure intended to ensure that banking organizations maintain a sufficient pool of liquid assets to cover net cash outflows over a 30-day stress period.

On March 11, 2016, the Basel Committee on Banking Supervision released the second of three proposals on public disclosure of regulatory metrics and qualitative data by banking institutions. The proposal requires disclosures on market risk to be more granular for both the standardized approach and regulatory approval of internal models.[22]

U.S. implementation

The U.S. Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules.[23] 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:

As of January 2014, the United States has been on track to implement many of the Basel III rules, despite differences in ratio requirements and calculations.[25]

Europe implementation

The implementing act of the Basel III agreements in the European Union has been the new legislative package comprising Directive 2013/36/EU (CRD IV) and Regulation (EU) No. 575/2013 on prudential requirements for credit institutions and investment firms (CRR).[26]

The new package, approved in 2013, replaced the Capital Requirements Directives (2006/48 and 2006/49).[27]

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 60% requirement. 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: 100% LCR is expected.

Analysis of Basel III impact

In the United States higher capital requirements resulted in contractions in trading operations and the number of personnel employed on trading floors.[28]

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.[29] 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.[30] 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.[29]

Criticism

Think tanks such as the World Pensions Council have argued that Basel III merely builds on and further expands the existing Basel II regulatory base without fundamentally questioning 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.[31][32] The conflicted and unreliable credit ratings of these agencies is generally seen as a major contributor to the US housing bubble.

Opaque treatment of all derivatives contracts is also criticized. While institutions have many legitimate ("hedging", "insurance") risk reduction reasons to deal in derivatives, the Basel III accords:

Since derivatives present major unknowns in a crisis these are seen as major failings by some critics [33] causing several to claim that the "too big to fail" status remains with respect to major derivatives dealers who aggressively took on risk of an event they did not believe would happen - but did. As Basel III does not absolutely require extreme scenarios that management flatly rejects to be included in stress testing this remains a vulnerability. Standardized external auditing and modelling is an issue proposed to be addressed in Basel 4 however.

A few critics argue that capitalization regulation is inherently fruitless due to these and similar problems and - despite an opposite ideological view of regulation - agree that "too big to fail" persists.[34]

Basel III has been criticized similarly for its paper burden and risk inhibition by banks, organized in the Institute of International Finance, an international association of global banks based in Washington, D.C., who argue that it would "hurt" both their business and overall economic growth. The OECD estimated that implementation of Basel III would decrease annual GDP growth by 0.05–0.15%,[29][35] blaming the slow recovery from the financial crisis of 2007–08 on the regulation.[36][37] Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework.[38] The American Bankers Association,[39] 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 Senators Ben Cardin and Barbara Mikulski and Representatives Chris Van Hollen and Elijah Cummings, voiced opposition to Basel III in their comments to the Federal Deposit Insurance Corporation,[40] saying that the Basel III proposals, if implemented, would hurt small banks by increasing "their capital holdings dramatically on mortgage and small business loans".[41]

Others have argued that Basel III did not go far enough to regulate banks as inadequate regulation was a cause of the financial crisis.[42] However, these arguments should be examined closely, as Basel III was not in effect until after the financial crisis occurred. 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.[43]

Further studies

In addition to articles used for references (see References), this section lists links to publicly available high-quality studies on Basel III. This section may be updated frequently as Basel III remains 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

References

  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. 1 2 http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf
  4. http://www.riskbank.com.br/anexo/boletim0910.pdf
  5. http://www.bis.org/publ/bcbs270.pdf
  6. http://www.allbankingsolutions.com/banking-tutor/basel-iii-accord-basel-3-norms.shtml
  7. "US Federal Reserve Bank announces the minimum Basel III leverage ratio". Archived from the original on 12 July 2013.
  8. http://www.bis.org/publ/bcbs189.pdf
  9. Hal S. Scott (16 June 2011). "Testimony of Hal S. Scott before the Committee on Financial Services" (pdf). Committee on Financial Services, United States House of Representatives. pp. 12–13. Retrieved 17 November 2012.
  10. 1 2 http://www.federalreserve.gov/FR_notice_lcr_20131024.pdf
  11. "Fed Liquidity Proposal Seen Trading Safety for Costlier Credit". Bloomberg.
  12. 1 2 "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. External link in |website= (help)
  13. 1 2 3 "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. External link in |website= (help)
  14. http://www.federalreserve.gov/newsevents/press/bcreg/20131024a.htm
  15. http://www.ft.com/cms/s/0/9f61345c-3cb1-11e3-a8c4-00144feab7de.html#axzz2jWZZfSmH
  16. "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.
  17. "Basel II Comprehensive version part 2: The First Pillar – Minimum Capital Requirements" (pdf). November 2005. p. 86.
  18. Susanne Craig (8 January 2012). "Bank Regulators to Allow Leeway on Liquidity Rule". New York Times. Retrieved 10 January 2012.
  19. Proposed Basel III Guidelines: A Credit Positive for Indian Banks
  20. "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. External link in |website= (help)
  21. "First take: Liquidity coverage ratio". http://www.pwc.com/us/en/financial-services/regulatory-services/publications/first-take-liquidity-coverage-ratio.jhtml. PwC Financial Services Regulatory Practice, September, 2014. External link in |website= (help)
  22. "Five key points from Basel’s enhanced disclosure proposal". PwC Financial Services Risk and Regulatory Practice, March, 2016.
  23. Edward Wyatt (20 December 2011). "Fed Proposes New Capital Rules for Banks". New York Times. Retrieved 6 July 2012.
  24. "Press Release". Federal Reserve Bank. 20 December 2011. Retrieved 6 July 2012.
  25. "Basel leverage ratio: No cover for US banks" (PDF). http://www.pwc.com/us/en/financial-services/regulatory-services/publications/dodd-frank-basel-leverage-ratio.jhtml. PwC Financial Services Regulatory Practice, January 2014. External link in |website= (help)
  26. http://ec.europa.eu/finance/bank/regcapital/legislation-in-force/index_en.htm
  27. http://www.eba.europa.eu/regulation-and-policy/implementing-basel-iii-europe
  28. Nathaniel Popper (July 23, 2015). "In Connecticut, the Twilight of a Trading Hub". The New York Times. Retrieved July 26, 2015. ...the set of international banking rules that have had the single largest impact require banks to hold capital as a buffer against trading losses — rules broadly referred to as Basel III.
  29. 1 2 3 Patrick Slovik; Boris Cournède (2011). "Macroeconomic Impact of Basel III". OECD Economics Department Working Papers. OECD Publishing. doi:10.1787/5kghwnhkkjs8-en.
  30. ?
  31. M. Nicolas J. Firzli, "A Critique of the Basel Committee on Banking Supervision" Revue Analyse Financière, 10 November 2011 & Q2 2012
  32. Barr, David G. (23 November 2013). "What We Thought We Knew: The Financial System and Its Vulnerabilities" (pdf). Bank of England.
  33. http://scholar.harvard.edu/files/vstavrak/files/derivregntr_article.pdf
  34. http://www.heritage.org/research/reports/2014/04/basel-iii-capital-standards-do-not-reduce-the-too-big-to-fail-problem
  35. Jones, Huw (September 2010). "Basel rules to have little impact on economy" (pdf). Reuters.
  36. John Taylor (September 2012). "Regulatory Expansion Versus Economic Expansion in Two Recoveries".
  37. Philip Suttle (3 March 2011). "The Macroeconomic Implications of Basel III". Institute of International Finance. Retrieved 17 November 2012.
  38. Patrick Slovik (2012). "Systemically Important Banks and Capital Regulations Challenges". OECD Economics Department Working Papers. OECD Publishing. doi:10.1787/5kg0ps8cq8q6-en.
  39. 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
  40. 95 entities listed at http://www.fdic.gov/regulations/laws/federal/2012-ad-95-96-97/2012-ad95.html Retrieved 13 March 2013
  41. http://www.icba.org/files/ICBASites/PDFs/test112912.pdf
  42. 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.
  43. NY Times 1 July 2013 http://dealbook.nytimes.com/2013/01/07/easing-of-rules-for-banks-acknowledges-reality/

External links

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