What Is Basel III?
Introduced in 2009, Basel III is a global regulatory accord aiming to reduce risk in the banking sector. It mandates banks to maintain specific leverage ratios and reserve capital levels. The implementation process continues into 2022.
Envisioned as a transformative leap to fortify banking regulation, Basel III was introduced in 2009 by a consortium of central banks from 28 countries. This regulatory accord, born in the aftermath of the 2007-2008 financial crisis and its subsequent recession, aims to enhance supervision, risk management, and regulation of the banking sector. As of 2022, the implementation process is still underway, marking a progressive stride towards a more robust banking regulatory framework.
Basel III: Strengthening Banking Regulations Globally
In response to the 2007-2008 financial crisis, the Basel Committee on Banking Supervision, representing central banks from 28 countries and headquartered in Basel, Switzerland, introduced Basel III. This Third Basel Accord aims to address overleveraging and undercapitalization issues that surfaced during the crisis, building upon the foundations laid by Basel I and Basel II, and enhancing the global banking regulatory framework initiated in 1975. By promoting financial stress resilience, improved risk management, and transparency, Basel III seeks to fortify individual banks against shocks and safeguard the global economy. Initially set for voluntary implementation by 2015, the deadline has been postponed multiple times, with the current target being January 1, 2023.
Minimum Capital Requirements: Understanding Basel III
Basel III, a significant regulatory framework for banks, categorizes capital into two distinct tiers with varying qualities. Tier 1 encompasses core capital and disclosed reserves on financial statements, providing a cushion to withstand losses and ensure operational continuity during stressful situations.
On the other hand, Tier 2 consists of supplementary capital, including undisclosed reserves and unsecured subordinated debt instruments. While Tier 1 capital is deemed more secure and liquid, Tier 2 serves as a supplementary resource.
A bank's total capital is determined by the combination of both tiers. Basel III mandates that banks maintain a minimum total capital ratio of 8% of risk-weighted assets (RWAs), of which at least 6% must be Tier 1 capital. The remaining portion may be covered by Tier 2 capital. Notably, Basel III raised the required portion of Tier 1 capital from 4% to 6%, whereas Basel II also demanded a minimum total capital ratio of 8% without specifying the composition of Tier 1 assets. Moreover, Basel III eliminated Tier 3, an even riskier form of capital, from the calculation. These changes seek to fortify the banking sector and enhance its resilience in the face of potential risks.
Strengthening Banks: Basel III's Capital Buffers
To enhance the banking sector's resilience, Basel III introduced countercyclical capital buffers—an additional reserve, akin to a rainy day fund for banks. These buffers, ranging from 0% to 2.5% of a bank's risk-weighted assets (RWAs), can be enforced during economic expansions. By doing so, banks are better prepared with sufficient capital during economic downturns, like recessions, to offset potential losses.
Combining the minimum capital and buffer requirements, banks may need to maintain reserves of up to 10.5%. Moreover, these countercyclical capital buffers must exclusively comprise Tier 1 assets, ensuring a stronger financial foundation.
Basel III's Safeguard: Leverage and Liquidity Measures
Basel III introduced crucial leverage and liquidity requirements to protect against risky lending and ensure ample liquidity during financial turmoil. For "global systemically important banks," a leverage ratio was established, calculated as Tier 1 capital divided by total assets, with a 3% minimum requirement.
The framework also implemented rules related to liquidity, including the liquidity coverage ratio, which mandates that banks hold sufficient high-quality liquid assets (HQLA) to withstand a 30-day liquidity stress period without significant loss of value.
Furthermore, the net stable funding (NSF) ratio compares a bank's available stable funding with the required stable funding based on liquidity, maturities, and asset risk. Banks must maintain an NSF ratio of at least 100%, encouraging them to use more stable funding sources and avoid relying on short-term wholesale funding.
Basel III: Revolutionizing Global Banking
Basel III, the latest iteration of the Basel Accords, aims to enhance regulation, supervision, and risk management in the international banking sector. It addresses shortcomings exposed during the 2007-2008 financial crisis, caused by the inadequacies of Basel I and Basel II.
Certain parts of Basel III have already been implemented in specific countries, while the rest are scheduled for rollout on Jan. 1, 2023, with a phased approach over five years.
As the third in the series of Basel Accords, Basel III was crafted by the Basel Committee on Banking Supervision, comprising central banks worldwide, including the Federal Reserve in the United States. With the goal of rectifying regulatory gaps exposed during the 2007-2008 financial crisis, Basel III is set to achieve full implementation by 2028.