Basel III

Basel III (or the Third Basel Accord) is a global, vol-untary regulatory framework on bank capital adequacy,stress testing and market liquidity risk. It was agreedupon by the members of the Basel Committee on Bank-ing Supervision in 2010–11, and was scheduled to beintroduced from 2013 until 2015; however, changesfrom 1 April 2013 extended implementation until 31March 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 deficienciesin financial regulation revealed by the financial crisis of2007–08. Basel III was supposed to strengthen bankcapital requirements by increasing bank liquidity and de-creasing bank leverage.

1 Overview

Unlike Basel I and Basel II, which focus primarily on thelevel of bank loss reserves that banks are required to hold,Basel III focuses primarily on the risk of a run on thebank by requiring differing levels of reserves for differ-ent forms of bank deposits and other borrowings. There-fore Basel III does not, for the most part, supersede theguidelines known as Basel I and Basel II; rather, it willwork alongside them.

2 Key principles

2.1 Capital requirements

The original Basel III rule from 2010 was supposed to re-quire banks to hold 4.5% of common equity (up from2% in Basel II) and 6% of Tier I capital (includingcommon equity and up from 4% in Basel II) of "risk-weighted assets" (RWAs).[3] Basel III introduced twoadditional “capital buffers”—a “mandatory capital con-servation buffer” of 2.5% and a “discretionary counter-cyclical buffer” to allow national regulators to require upto an additional 2.5% of capital during periods of highcredit growth.

2.2 Leverage ratio

Basel III introduced a minimum “leverage ratio”. Theleverage ratio was calculated by dividing Tier 1 capi-tal by the bank’s average total consolidated assets (not

risk weighted);[4][5] The banks were expected to main-tain a leverage ratio in excess of 3% under Basel III.In July 2013, the U.S. Federal Reserve announced thatthe minimum Basel III leverage ratio would be 6% for 8Systemically important financial institution (SIFI) banksand 5% for their insured bank holding companies.[6]

2.3 Liquidity requirements

Basel III introduced two required liquidity ratios.[7] The“Liquidity Coverage Ratio” was supposed to require abank to hold sufficient high-quality liquid assets to coverits total net cash outflows over 30 days; the Net StableFunding Ratio was to require the available amount of sta-ble funding to exceed the required amount of stable fund-ing over a one-year period of extended stress.[8]

2.3.1 U.S. version of the Basel Liquidity CoverageRatio requirements

On 24 October 2013, the Federal Reserve Board of Gov-ernors approved an interagency proposal for the U.S.version of the Basel Committee on Banking Supervi-sion (BCBS)'s Liquidity Coverage Ratio (LCR). The ra-tio would apply to certain U.S. banking organizations andother systemically important financial institutions.[9] Thecomment period for the proposal is scheduled to close by31st January 2014The United States’ LCR proposal came out signifi-cantly tougher than BCBS’s version, especially for largerbank holding companies.[10] The proposal requires finan-cial institutions and FSOC designated nonbank financialcompanies[11] to have an adequate stock of high-qualityliquid assets (HQLA) that can be quickly liquidated tomeet liquidity needs over a short period of time.The LCR consists of two parts: the numerator is the valueof HQLA, and the denominator consists of the total netcash outflows over a specified stress period (total expectedcash outflows minus total expected cash inflows).[12]

The Liquidity Coverage Ratio applies to U.S. banking op-erations with assets of more than $10 billion. The pro-posal would require:

• Large BankHolding Companies (BHC) – those withover $250 billion in consolidated assets, or more inon-balance sheet foreign exposure, and to systemi-cally important, non-bank financial institutions;[11]

1

2 3 IMPLEMENTATION

to hold enough HQLA to cover 30 days of net cashoutflow. That amount would be determined basedon the peak cumulative amount within the 30-dayperiod.[9]

• Regional firms (those with between $50 and $250billion in assets) would be subject to a “modified”LCR at the (BHC) level only. The modified LCRrequires the regional firms to hold enough HQLAto cover 21 days of net cash outflow. The net cashoutflow parameters are 70% of those applicable tothe larger institutions and do not include the require-ment to calculate the peak cumulative outflows[12]

• Smaller BHCs, those under $50 billion, would re-main subject to the prevailing qualitative supervi-sory framework.[13]

The U.S. proposal divides qualifying HQLAs into threespecific categories (Level 1, Level 2A, and Level 2B).Across the categories the combination of Level 2A and2B assets cannot exceed 40% HQLA with 2B assets lim-ited to a maximum of 15% of HQLA.[12]

• Level 1 represents assets that are highly liquid (gen-erally those risk-weighted at 0% under the BaselIII standardized approach for capital) and receiveno haircut. Notably, the Fed chose not to includeGSE-issued securities in Level 1, despite industrylobbying, on the basis that they are not guaranteedby the "full faith and credit" of the U.S. government.

• Level 2A assets generally include assets that wouldbe subject to a 20% risk-weighting under BaselIII and includes assets such as GSE-issued and -guaranteed securities. These assets would be subjectto a 15% haircut which is similar to the treatment ofsuch securities under the BCBS version.

• Level 2B assets include corporate debt and equitysecurities and are subject to a 50% haircut. TheBCBS and U.S. version treats equities in a similarmanner, but corporate debt under the BCBS versionis split between 2A and 2B based on public creditratings, unlike the U.S. proposal. This treatment ofcorporate debt securities is the direct impact of theDodd–Frank Act's Section 939, which removed ref-erences to credit ratings, and further evidences theconservative bias of U.S. regulators’ approach to theLCR.

The proposal requires that the LCR be at least equal toor greater than 1.0 and includes a multiyear transition pe-riod that would require: 80% compliance starting 1 Jan-uary 2015, 90% compliance starting 1 January 2016, and100% compliance starting 1 January 2017.[14]

Lastly, the proposal requires both sets of firms (large bankholding companies and regional firms) subject to the LCR

requirements to submit remediation plans to U.S. regula-tors to address what actions would be taken if the LCRfalls below 100% for three or more consecutive days.

3 Implementation

3.1 Summary of originally (2010) pro-posed changes in Basel Committee lan-guage

• First, the quality, consistency, and transparency ofthe capital base will be raised.

• Tier 1 capital: the predominant form of Tier1 capital must be common shares and retainedearnings

• Tier 2 capital: supplementary capital, how-ever, the instruments will be harmonised

• Tier 3 capital will be eliminated.[15]

• Second, the risk coverage of the capital frameworkwill be strengthened.

• Promotemore integratedmanagement of mar-ket and counterparty credit risk

• Add the credit valuation adjustment–risk dueto deterioration in counterparty’s credit rating

• Strengthen the capital requirements for coun-terparty credit exposures arising from banks’derivatives, repo and securities financing trans-actions

• Raise the capital buffers backing these expo-sures

• Reduce procyclicality and• Provide additional incentives to move OTCderivative contracts to qualifying central coun-terparties (probably clearing houses). Cur-rently, the BCBS has stated derivatives clearedwith a QCCPwill be risk-weighted at 2% (Therule is still yet to be finalized in the U.S.)

• Provide incentives to strengthen the risk man-agement of counterparty credit exposures

• Raise counterparty credit risk managementstandards by including wrong-way risk

• Third, a leverage ratio will be introduced as asupplementary measure to the Basel II risk-basedframework. The ration was finalized on September3, 2014 and is known as the Supplementary Lever-age Ratio.[16]

• intended to achieve the following objectives:• Put a floor under the buildup of leveragein the banking sector

3.2 U.S. implementation 3

• Introduce additional safeguards againstmodel risk andmeasurement error by sup-plementing the risk based measure with asimpler measure that is based on gross ex-posures.

• Fourth, a series of measures is introduced to pro-mote the buildup of capital buffers in good timesthat can be drawn upon in periods of stress (“Re-ducing procyclicality and promoting countercyclicalbuffers”).

• Measures to address procyclicality:• Dampen excess cyclicality of the mini-mum capital requirement;

• Promote more forward looking provi-sions;

• Conserve capital to build buffers at indi-vidual banks and the banking sector thatcan be used in stress; and

• Achieve the broader macroprudential goal ofprotecting the banking sector from periods ofexcess credit growth.• Requirement to use long-term data hori-zons to estimate probabilities of default,

• downturn loss-given-default estimates,recommended in Basel II, to becomemandatory

• Improved calibration of the risk func-tions, which convert loss estimates intoregulatory capital requirements.

• Banks must conduct stress tests that in-clude widening credit spreads in reces-sionary scenarios.

• Promoting stronger provisioning practices(forward-looking provisioning):• Advocating a change in the account-ing standards towards an expected loss(EL) approach (usually, EL amount :=LGD*PD*EAD).[17]

• Fifth,a global minimum liquidity standard for inter-nationally active banks is introduced that includesa 30-day liquidity coverage ratio requirement un-derpinned by a longer-term structural liquidity ra-tio called the Net Stable Funding Ratio. (In January2012, the oversight panel of the Basel Committeeon Banking Supervision issued a statement sayingthat regulators will allow banks to dip below theirrequired liquidity levels, the liquidity coverage ra-tio, during periods of stress.[18])

• The Committee also is reviewing the need foradditional capital, liquidity or other supervisorymeasures to reduce the externalities created bysystemically important institutions.

As of September 2010, proposed Basel III norms askedfor 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 15 April, the Basel Committee on Banking Supervi-sion (BCBS) released the final version of its “SupervisoryFramework for Measuring and Controlling Large Expo-sures” (SFLE) that builds on longstanding BCBS guid-ance on credit exposure concentrations.[20]

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

3.2 U.S. implementation

The U.S. Federal Reserve announced in December 2011that it would implement substantially all of the Basel IIIrules.[22] It summarized them as follows, and made clearthey would apply not only to banks but also to all institu-tions with more than US$50 billion in assets:

• “Risk-based capital and leverage requirements” in-cluding first annual capital plans, conduct stresstests, and capital adequacy “including a tier onecommon risk-based capital ratio greater than 5 per-cent, under both expected and stressed conditions”– see scenario analysis on this. A risk-based capitalsurcharge

• Market liquidity, first based on the United States’own "interagency liquidity risk-management guid-ance issued in March 2010” that require liquiditystress tests and set internal quantitative limits, latermoving to a full Basel III regime - see below.

• The Federal Reserve Board itself would conducttests annually “using three economic and financialmarket scenarios”. Institutions would be encour-aged to use at least five scenarios reflecting improb-able events, and especially those considered impos-sible by management, but no standards apply yet toextreme scenarios. Only a summary of the three of-ficial Fed scenarios “including company-specific in-formation, would be made public” but one or moreinternal company-run stress tests must be run eachyear with summaries published.

• Single-counterparty credit limits to cut "credit expo-sure of a covered financial firm to a single counter-party as a percentage of the firm’s regulatory capital.Credit exposure between the largest financial com-panies would be subject to a tighter limit”.

4 4 ANALYSIS OF BASEL III IMPACT

• “Early remediation requirements” to ensure that“financial weaknesses are addressed at an earlystage”. One or more “triggers for remediation—such as capital levels, stress test results, and risk-management weaknesses—in some cases calibratedto be forward-looking” would be proposed by theBoard in 2012. “Required actions would vary basedon the severity of the situation, but could include re-strictions on growth, capital distributions, and exec-utive compensation, as well as capital raising or assetsales”.[23]

As of January 2014, the United States has been on trackto implement many of the Basel III rules, despite differ-ences in ratio requirements and calculations.[24]

3.3 Key milestones

3.3.1 Capital requirements

3.3.2 Leverage ratio

3.3.3 Liquidity requirements

4 Analysis of Basel III impact

4.1 Macroeconomic impact

AnOECD study released on 17 February 2011, estimatedthat the medium-term impact of Basel III implementa-tion on GDP growth would be in the range of −0.05% to−0.15% per year.[25] Economic output would be mainlyaffected by an increase in bank lending spreads, as bankspass a rise in bank funding costs, due to higher capi-tal requirements, to their customers. To meet the capi-tal requirements originally effective in 2015 banks wereestimated to increase their lending spreads on averageby about 15 basis points. Capital requirements effec-tive as of 2019 (7% for the common equity ratio, 8.5%for the Tier 1 capital ratio) could increase bank lendingspreads by about 50 basis points.[26] The estimated effectson GDP growth assume no active response from mone-tary policy. To the extent that monetary policy would nolonger be constrained by the zero lower bound, the BaselIII impact on economic output could be offset by a re-duction (or delayed increase) in monetary policy rates byabout 30 to 80 basis points.[25]

4.2 Criticism

Think tanks such as the World Pensions Council have ar-gued that Basel III merely builds on and further expandsthe existing Basel II regulatory base without fundamen-tally questioning its core tenets, notably the ever-growingreliance on standardized assessments of “credit risk”mar-keted by two private sector agencies- Moody’s and S&P,

thus using public policy to strengthen anti-competitiveduopolistic practices.[27][28] The conflicted and unreliablecredit ratings of these agencies is generally seen as a ma-jor contributor to the US housing bubble.Opaque treatment of all derivatives contracts is also crit-icized. While institutions have many legitimate (“hedg-ing”, “insurance”) risk reduction reasons to deal in deriva-tives, the Basel III accords:

• treat insurance buyers and sellers equally eventhough sellers take onmore concentrated risks (liter-ally purchasing them) which they are then expectedto offset correctly without regulation

• do not require organizations to investigate correla-tions of all internal risks they own

• do not tax or charge institutions for the systematic oraggressive externalization or conflicted marketing ofrisk - other than requiring an orderly unravelling ofderivatives in a crisis and stricter record keeping

Since derivatives present major unknowns in a crisis theseare seen as major failings by some critics [29] causing sev-eral to claim that the “too big to fail” status remains withrespect to major derivatives dealers who aggressively tookon risk of an event they did not believe would happen -but did. As Basel III does not absolutely require extremescenarios that management flatly rejects to be includedin stress testing this remains a vulnerability. Standard-ized external auditing and modelling is an issue proposedto be addressed in Basel 4 however.

A few critics argue that capitalization regulation is inher-ently fruitless due to these and similar problems and - de-spite an opposite ideological view of regulation - agreethat “too big to fail” persists.[30]

Basel III has been criticized similarly for its paper burdenand risk inhibition by banks, organized in the Instituteof International Finance, an international association ofglobal banks based in Washington, D.C., who arguethat it would “hurt” both their business and overall eco-nomic growth. The OECD estimated that implemen-tation of Basel III would decrease annual GDP growthby 0.05–0.15%,[25][31] blaming the slow recovery fromthe financial crisis of 2007–08 on the regulation.[32][33]Basel III was also criticized as negatively affecting thestability of the financial system by increasing incen-tives of banks to game the regulatory framework.[34] TheAmerican Bankers Association,[35] community banksorganized in the Independent Community Bankers ofAmerica, and some of the most liberal Democrats in theU.S. Congress, including the entire Maryland congres-sional delegation with Democratic Senators Ben Cardinand Barbara Mikulski and Representatives Chris VanHollen and Elijah Cummings, voiced opposition to BaselIII in their comments to the Federal Deposit InsuranceCorporation,[36] saying that the Basel III proposals, if im-plemented, would hurt small banks by increasing “their

5

capital holdings dramatically on mortgage and small busi-ness loans”.[37]

Others have argued that Basel III did not go far enough toregulate banks as inadequate regulation was a cause of thefinancial crisis.[38] On 6 January 2013 the global bankingsector won a significant easing of Basel III Rules, whenthe Basel Committee on Banking Supervision extendednot only the implementation schedule to 2019, but broad-ened the definition of liquid assets.[39]

4.3 Further studies

In addition to articles used for references (see Refer-ences), this section lists links to publicly available high-quality studies on Basel III. This section may be updatedfrequently as Basel III remains under development.

5 See also

• Basel I

• Basel II

• Basel 4

• Systemically important financial institution

• Operational risk

• Operational risk management

6 References[1] “Group of Governors and Heads of Supervision an-

nounces higher global minimum capital standards” (PDF).Basel Committee on Banking Supervision. 12 September2010.

[2] Financial Times report Oct 2012

[3] http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf

[4] http://www.investopedia.com/terms/t/tier-1-leverage-ratio.asp#axzz2FJchzgOy

[5] http://www.allbankingsolutions.com/banking-tutor/basel-iii-accord-basel-3-norms.shtml

[6] “US Federal Reserve Bank announces the minimumBaselIII leverage ratio”.

[7] http://www.bis.org/publ/bcbs189.pdf

[8] 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 ofRepresentatives. pp. 12–13. Retrieved 17 November2012.

[9] http://www.federalreserve.gov/FR_notice_lcr_20131024.pdf

[10] “Fed Liquidity Proposal Seen Trading Safety for CostlierCredit”. Bloomberg.

[11] “Nonbank SIFIs: FSOC proposes initial designationsmore names to follow”. http://www.pwc.com/en_US/us/financial-services/regulatory-services/publications/assets/fs-reg-brief-nonbank-sifi.pdf, June 2013.

[12] “Liquidity coverage ratio: another brick inthe 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.

[13] http://www.federalreserve.gov/newsevents/press/bcreg/20131024a.htm

[14] http://www.ft.com/cms/s/0/9f61345c-3cb1-11e3-a8c4-00144feab7de.html#axzz2jWZZfSmH

[15] “Strengthening the resilience of the banking sector”(PDF). BCBS. December 2009. p. 15. Tier 3 will beabolished to ensure that market risks are met with thesame quality of capital as credit and operational risks.

[16] “First take: Supplementary lever-age ratio”. http://www.pwc.com/us/en/financial-services/regulatory-services/publications/first-take-supplementary-leverage-ratio-basel-iii.jhtml''.PwC Financial Services Regulatory Practice, September,2014.

[17] “Basel II Comprehensive version part 2: The First Pil-lar – Minimum Capital Requirements” (PDF). November2005. p. 86.

[18] Susanne Craig (8 January 2012). “Bank Regulators to Al-low Leeway on Liquidity Rule”. New York Times. Re-trieved 10 January 2012.

[19] Proposed Basel III Guidelines: A Credit Positive for IndianBanks

[20] “Stress testing: First take: Basel large exposures frame-work”. http://www.pwc.com/us/en/financial-services/regulatory-services/publications/index.jhtml''. PwC Fi-nancial Services Regulatory Practice, April 2014.

[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.

[22] Edward Wyatt (20 December 2011). “Fed Proposes NewCapital Rules for Banks”. New York Times. Retrieved 6July 2012.

[23] “Press Release”. Federal Reserve Bank. 20 December2011. Retrieved 6 July 2012.

6 7 EXTERNAL LINKS

[24] “Basel leverage ratio: No cover for USbanks” (PDF). http://www.pwc.com/us/en/financial-services/regulatory-services/publications/dodd-frank-basel-leverage-ratio.jhtml''. PwC FinancialServices Regulatory Practice, January 2014.

[25] Patrick Slovik; Boris Cournède (2011). “Macroe-conomic Impact of Basel III”. OECD EconomicsDepartment Working Papers. OECD Publishing.doi:10.1787/5kghwnhkkjs8-en.

[26] ?

[27] M. Nicolas J. Firzli, “A Critique of the Basel Commit-tee on Banking Supervision” Revue Analyse Financière,10 November 2011 & Q2 2012

[28] Barr, David G. (23 November 2013). “What We ThoughtWe Knew: The Financial System and Its Vulnerabilities”(PDF). Bank of England.

[29] http://scholar.harvard.edu/files/vstavrak/files/derivregntr_article.pdf

[30] http://www.heritage.org/research/reports/2014/04/basel-iii-capital-standards-do-not-reduce-the-too-big-to-fail-problem

[31] Jones, Huw (September 2010). “Basel rules to have littleimpact on economy” (PDF). Reuters.

[32] John Taylor (September 2012). “Regulatory ExpansionVersus Economic Expansion in Two Recoveries”.

[33] Philip Suttle (3 March 2011). “The Macroeconomic Im-plications of Basel III”. Institute of International Finance.Retrieved 17 November 2012.

[34] Patrick Slovik (2012). “Systemically Important Banksand Capital Regulations Challenges”. OECD Eco-nomics Department Working Papers. OECD Publishing.doi:10.1787/5kg0ps8cq8q6-en.

[35] Comment Letter on Proposals to Comprehensively Re-vise the Regulatory Capital Framework for U.S.BankingOrganizations(22 October 2012, http://www.sifma.org/workarea/downloadasset.aspx?id=8589940758

[36] 95 entities listed at http://www.fdic.gov/regulations/laws/federal/2012-ad-95-96-97/2012-ad95.html Retrieved13 March 2013

[37] http://www.icba.org/files/ICBASites/PDFs/test112912.pdf

[38] Reich, Robert. “Wall Street is Still Out of Control, andWhyObama Should Call for Glass-Steagall and a Breakupof Big Banks”. Robert Reich.org. Retrieved 2 March2013.

[39] NY Times 1 July 2013 http://dealbook.nytimes.com/2013/01/07/easing-of-rules-for-banks-acknowledges-reality/

7 External links• Basel III capital rules

• Basel III liquidity rules

• Bank Management and Control, Springer – Man-agement for Professionals, 2014

• U.S. Implementation of the Basel Capital Regula-tory Framework Congressional Research Service

• - Basel III in India

• How Basel III Affects SME Borrowing Capacity

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