What is Basel III?
Basel III is a list of comprehensive reforms whose goal is to strengthen the regulation, supervision, and risk management of the banking sector.
This is just the definition of Basel III. However, to gain a complete understanding of the framework, we need to understand its history and origin.
History of Basel
In 1974, a committee was formed by central bank governors of the Group of Ten countries*. This committee was named the Basel Committee on Banking Supervision (BCBS). Its main aim was to enhance quality banking regulations and converge worldwide banking standards to improve the safety and efficiency of banks around the globe.
The BCBS has released banking regulation standards and kept on revising the standards periodically to adjust with the changing times. After the global financial crisis between 2007 and 2009, many banks had gone bankrupt, and others were barely surviving. The BCBS issued its first version of Basel III, in late 2009, in response to the global financial crisis.
*Group of Ten countries includes – Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, the United States, Germany, and Sweden.
Detail Analysis of Basel III Framework
Basel three framework is built upon Basel I and Basel II frameworks. The focus of Basel III is to promote greater resilience at an individual bank level so that the risk of system-wide shocks is reduced.
The Basel III framework consists of three pillars as follows –
Pillars of Basel III accord
- Pillar-1 – Enhanced Minimum Capital & Liquidity Requirements
- Pillar-2 – Enhanced Supervisory Review Process for Firm-wide Risk Management and Capital Planning
- Pillar-3 – Enhanced Risk Disclosure and Market Discipline
There are many regulatory elements that have been proposed to fulfill the goals of all three pillars of the Basel III framework. Let’s discuss the regulatory elements in detail:
Regulatory Elements of Basel III
Minimum Capital Requirements
Higher Tier 1 and Tier 2 Capital
Capital reserves serve as a buffer to absorb shocks during a financial crisis. Banks are required to hold a certain percentage of their capital as reserves. This capital is further divided into Tier 1 and Tier 2 capital. Let’s understand each of these –
- Tier 1 Capital – Tier 1 capital is further divided into common equity tier 1 capital and additional tier 1 capital. Common equity tier 1 has optional dividends and no maturity. In contrast, additional tier 1 capital includes securities that are subordinated to most subordinated debt. This debt has no maturity, and its dividends can be canceled anytime. The Tier 1 capital ensures that each bank remains a going concern. It is the highest quality capital of the bank, and it can be used to write off losses.
- Tier 2 Capital – Tier 2 capital is additional capital that is less reliable than Tier 1 capital. It consists of unsecured subordinated debt with an original maturity of at least five years. In case of insolvency, Tier 2 capital protects the bank’s depositors. Thus it is categorized as a going concern reserve.
The Basel III accord proposes the following implementation in the quantity and quality of this capital. Following are the proposals:
- The minimum requirement for common equity Tier 1 is raised from a 2% level to 4.5%.
- The minimum Tier 1 capital requirement is increased from 4% to 6%.
Capital Conservation Buffer
A capital buffer is mandatory additional capital that the banks are required to hold over and above their minimum capital requirement. This is designed to ensure that banks build up enough capital so that they can meet the challenges of times of stress and financial crisis.
Under the new guidelines of Basel III, banks are now required to hold a capital conservation buffer of 2.5%. This brings the requirement of common equity Tier 1 capital to 7% (4.5% common equity tier 1 + 2.5% capital conservation buffer). As soon as the capital conservation buffer goes below the requirement, automatic safeguards apply, and the banks cannot pay dividends and bonus till this buffer is rebuilt.
Countercyclical measures are regulations used to deal with cyclical changes in the balance sheet of banks. In a credit cycle, during the time of expansion, spare capital has to be set aside, whereas, during the time of contraction, these spare capital requirements can be relaxed.
According to Basel III, the countercyclical capital buffer should be in the range of 0 to 2.5%. This is in addition to minimum capital requirements and a capital conservation buffer.
Liquidity Standard and Leverage Ratio
In order to ensure that banks do not run out of liquidity in times of crisis, Basel III puts in place regulations to maintain liquidity standards. Following is the list of regulations –
- Liquidity Coverage Ratio (LCR) – Regulations of liquidity coverage ratio are designed to ensure that banks maintain an adequate level of high-quality liquid assets that can meet their liquidity needs for the next 30 days.
- Net Stable Funding Ratio (NSFR) – This particular standard ensures that banks hold an amount of long-term funding that is at least equal to their long-term assets. In a way, it covers the entire balance sheet and provides incentives to the bank to use stable sources of funding.
Capital Leverage Ratio
The leverage ratio as per Basel III standards is based on Tier 1 capital. The capital leverage ratio is used to determine the capital adequacy of banks. It also puts a constraint on how the bank may leverage its capital. This ratio is a supplementary requirement.
Basel III accord requires that the banks keep their capital leverage ratio minimum of 3%.
As the Financial Stability Board states – “Full, timely, and consistent implementation of Basel III is fundamental to a sound and properly functioning banking system that is able to support economic recovery and growth on a sustainable basis.” However, adopting Basel III regulations is a challenge for all banks. To aid an effective and timely adoption, the Basel Committee has recommended a timeline of phase-wise implementations to give banks the time to build quality capital and appropriate standards. As per the latest BIS press release, the final Basel III minimum requirements are expected to be implemented by 1st January 2022 and fully phased in by 1st January 2027.