Basel III

Overview

Basel III is a framework published by the Basel Committee on Banking Supervision (BCBS) in response to the deficiencies in financial regulation revealed by the 2008 financial crisis. It sets international standards and recommendations for bank capital requirements, stress tests, liquidity regulations, and leverage, with the goal of mitigating the risk of bank runs and bank failures. Basel III builds upon the standards of Basel II, introduced in 2004, and Basel I, introduced in 1988. Basel III are minimum recommendations; each country that chooses to adopt Basel III must translate the guidance into laws that are binding upon its financial institutions.

History

The Basel III standards were published by the BCBS in September 2010 and began to be implemented by central banks shortly thereafter. Clarifications and guidance were published intermittently. The standards were modified by Basel III: Finalising post-crisis reforms, (also known as Basel III Endgame, Basel 3.1, and Capital Requirements Regulations III). These include the Fundamental Review of the Trading Book, which handles how capital requirements are calculated. Implementation has been completed only in some countries and is scheduled to be completed in the European Union in 2027, with a 3-year phase-in period. In the United Kingdom, the Standardised Approach (SA) will be implemented on January 1, 2027, and the Internal Models Approach (IMA) will be implemented on January 1, 2028. Japan began phasing in Basel 3.1 standards between 2024 and 2029. It will be implemented in India in April 2027. It was implemented in Canada in the early 2020s. In the United States, an initial proposal from regulators published in 2023 received pushback and was rewritten in 2026; the timeline for implementation is uncertain.

Key principles

The quality, consistency, and transparency of the capital base was raised. Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings. This is subject to prudential deductions, including goodwill and intangible assets. Tier 2 capital: supplementary capital, however, the instruments were harmonised. Tier 3 capital was eliminated. The risk coverage of the capital framework was strengthened. Promoted more integrated management of market and counterparty credit risk Added the credit valuation adjustment–risk due to deterioration in counterparty's credit rating Strengthened the capital requirements for counterparty credit exposures arising from banks' derivatives, repo and securities financing transactions Raised the capital buffers backing these exposures Reduced procyclicality and Provided additional incentives to move OTC derivative contracts to qualifying central counterparties (probably clearing houses). Where a bank acts as a clearing member of a central counterparty for its own purposes, a risk weight of 2% must be applied to the bank’s trade exposure to the central counterparty. Provided incentives to strengthen the risk management of counterparty credit exposures Raised counterparty credit risk management standards by including wrong way risk A series of measures was introduced to promote the buildup of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers"). Measures to address procyclicality: Dampen excess cyclicality of the minimum capital requirement; Promoted more forward looking provisions; Conserved capital to build buffers at individual banks and the banking sector that can be used in stress; and Achieved the broader macroprudential goal of protecting the banking sector from periods of excess credit growth. Requirement to use long-term data horizons to estimate probabilities of default downturn loss given default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. Banks must conduct stress tests that include scenarios of widening yield spreads in recessions. Stronger provisioning practices (forward-looking provisioning): Advocates a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).

Common Equity Tier 1 (CET1) capital requirements

CET1

RWAs

=

CET1

ratio

{\displaystyle {\frac {\mbox{CET1}}{\mbox{RWAs}}}={\mbox{CET1}}\;{\textrm {ratio}}}

Basel III requires banks to have a minimum CET1 ratio (Common Tier 1 capital divided by risk-weighted assets (RWAs)) at all times of:

4.5% Plus:

A mandatory "capital conservation buffer" or "stress capital buffer requirement", equivalent to at least 2.5% of risk-weighted assets, but could be higher based on results from stress tests, as determined by national regulators. Plus:

If necessary, as determined by national regulators, a "counter-cyclical buffer" of up to an additional 2.5% of RWA as capital during periods of high credit growth. This must be met by CET1 capital. In the U.S., an additional 1% is required for globally systemically important financial institutions. It also requires minimum Tier 1 capital of 6% at all times. Common Tier 1 capital comprises shareholders equity (including audited profits), less deductions of accounting reserve that are not believed to be loss absorbing "today", including goodwill and other intangible assets. To prevent the potential of double-counting of capital across the economy, bank's holdings of other bank shares are also deducted.

Tier 2 capital requirements

Tier 2 capital + Tier 1 capital is required to be above 8%.

Leverage ratio requirements

Leverage ratio is calculated by dividing Tier 1 capital by the bank's leverage exposure. The leverage exposure is the sum of the exposures of all on-balance sheet assets, 'add-ons' for derivative exposures and securities financing transactions (SFTs), and credit conversion factors for off-balance sheet items. Basel III introduced a minimum leverage ratio of 3%.

Tier 1 Capital

Total exposure

≥ 3 %

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

The U.S. established another ratio, the supplemental leverage ratio, defined as Tier 1 capital divided by total assets. It is required to be above 3.0%. A minimum leverage ratio of 5% is required for large banks and systemically important financial institutions. In the EU, the minimum bank leverage ratio is the same 3% as required by Basel III. The UK requires a minimum leverage ratio, for banks with deposits greater than £50 billion, of 3.25%. This higher minimum reflects the PRA's differing treatment of the leverage ratio, which excludes central bank reserves in 'Total exposure' of the calculation.

Liquidity requirements

Basel III introduced two required liquidity/funding ratios.

Liquidity coverage ratio

The liquidity coverage ratio requires banks to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days under a stressed scenario. This was implemented because some adequately-capitalized banks faced difficulties because of poor liquidity management. 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). Mathematically it is expressed as follows:

LCR

=

High quality liquid assets Total net liquidity outflows over 30 days

≥ 100 %

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

Regulators can allow banks to dip below their required liquidity levels per the liquidity coverage ratio during periods of stress. In the U.S. version, Bonds and securities issued by financial institutions, as well as certain mortgage backed securities, which can become illiquid during a financial crisis, are not included in HQLA.

Net stable funding ratio

The net stable funding ratio requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress. The Net Stable Funding Ratio seeks to calculate the proportion of Available Stable Funding (ASF), via equity and certain liabilities, over Required Stable Funding (RSF) via the assets.

NSFR

=

Available amount of stable funding

Required amount of stable funding

=

ASF

RSF

> 100 %

{\displaystyle {\text{NSFR}}={\frac {\mbox{Available amount of stable funding}}{\mbox{Required amount of stable funding }}}={\frac {\mbox{ASF}}{\mbox{RSF}}}>100\%}

These components of stable funding are not equally weighted. Off-balance sheet categories are also weighted as they contribute to both the assets and liabilities. This is best explained by the potential for contingent calls on funding liquidity (revocable and irrevocable line of credit and liquidity facilities to clients). Therefore off-balance sheet commitments need to be funded, with the stable funding. This may help prevent the excessive use of the shadow banking system, including special purpose entity and structured investment vehicle, as these often benefit from liquidity facilities (so-called back-stop facilities) granted by the bank.

Counterparty risk: CCPs and SA-CCR

The standardised approach for counterparty credit risk (SA-CCR) replaced the current exposure method. SA-CCR is used to measure the exposure at default of derivative transactions and in the leverage exposure measure and non-modelled Risk Weighted Asset calculations, with potential exposure to central counterparty clearing default.

Capital requirements for equity investments in funds

The framework requires banks to take account of an investment fund's leverage when determining risk-based capital requirements associated with the investment and more appropriately reflecting the risk of the fund's underlying investments, including the use of a 1,250% risk weight for situations in which there is not sufficient transparency.

Limiting large exposure to external and internal counterparties

The Large Exposures Framework (LEX) restricts a financial institution's maximum loss from any single counterparty failure to 25% of its Tier 1 capital. Exposures between Global systemically important financial institution have a stricter limit of 15% of Tier 1 capital. An exposure is defined as a "large exposure" if it reaches or exceeds 10% of the bank's eligible capital base.