🏦Financial Services Reporting Unit 9 – Basel III: Capital and Liquidity Standards

What's Basel III?

• Global regulatory framework developed by the Basel Committee on Banking Supervision (BCBS) in response to the 2007-2009 financial crisis
• Builds upon and enhances the previous Basel I and Basel II frameworks
• Aims to strengthen the resilience of the banking sector by improving risk management, increasing capital requirements, and introducing new liquidity standards
• Focuses on addressing the shortcomings exposed during the financial crisis, such as excessive leverage, inadequate liquidity buffers, and insufficient loss-absorbing capacity
• Seeks to promote a more stable and sustainable global banking system that can withstand economic shocks and reduce the risk of future financial crises
• Consists of a comprehensive set of reforms covering capital adequacy, liquidity risk, leverage ratio, and systemic risk
• Introduces a macroprudential overlay to address system-wide risks and the interconnectedness of financial institutions

Key Players and Timeline

• Basel Committee on Banking Supervision (BCBS) responsible for developing and overseeing the implementation of Basel III
  • Comprises central bank governors and banking supervisors from 28 jurisdictions worldwide
• G20 leaders endorsed Basel III in November 2010 at the Seoul Summit
• Initial Basel III rules published in December 2010, with subsequent revisions and updates released in the following years
• Phased implementation timeline originally set from 2013 to 2019, with transitional arrangements for certain requirements
  • Capital conservation buffer phased in between January 1, 2016, and January 1, 2019
  • Liquidity Coverage Ratio (LCR) introduced on January 1, 2015, with a gradual increase to 100% by January 1, 2019
• Net Stable Funding Ratio (NSFR) became a minimum standard on January 1, 2018
• Leverage ratio disclosure requirements effective from January 1, 2015, with a minimum requirement of 3% implemented on January 1, 2018
• Revisions to the market risk framework (Fundamental Review of the Trading Book) published in January 2019, with implementation by January 1, 2023

Core Components of Basel III

• Enhanced capital requirements
  • Increased quality and quantity of regulatory capital
  • Introduction of capital conservation buffer and countercyclical capital buffer
• Liquidity standards
  • Liquidity Coverage Ratio (LCR) to ensure short-term resilience
  • Net Stable Funding Ratio (NSFR) to promote long-term funding stability
• Leverage ratio
  • Non-risk-based backstop measure to limit excessive leverage
• Systemic risk and interconnectedness
  • Additional capital requirements for systemically important banks (G-SIBs and D-SIBs)
  • Enhanced supervisory framework for large and complex financial institutions
• Risk coverage enhancements
  • Strengthened capital requirements for counterparty credit risk, securitizations, and trading book exposures
• Macroprudential overlay
  • Tools to address system-wide risks and the procyclicality of the financial system
• Disclosure and market discipline
  • Enhanced disclosure requirements to improve transparency and market discipline

Capital Requirements Breakdown

• Minimum Common Equity Tier 1 (CET1) ratio of 4.5% of risk-weighted assets (RWA)
• Additional Tier 1 capital of 1.5% of RWA, bringing the total Tier 1 capital ratio to 6%
• Tier 2 capital of 2% of RWA, resulting in a total capital ratio of 8%
• Capital conservation buffer (CCB) of 2.5% of RWA, composed of CET1, to be phased in gradually
  • Constraints on capital distributions and discretionary bonus payments when banks fall below the CCB
• Countercyclical capital buffer (CCyB) of up to 2.5% of RWA, set by national authorities based on macroeconomic conditions
• Higher capital requirements for systemically important banks (G-SIBs and D-SIBs)
  • Additional CET1 capital surcharge ranging from 1% to 3.5% of RWA, depending on the bank's systemic importance
• Enhancements to the definition and quality of regulatory capital
  • Greater focus on common equity and retained earnings as the highest quality capital
  • Stricter criteria for Additional Tier 1 and Tier 2 capital instruments

Liquidity Standards Explained

• Liquidity Coverage Ratio (LCR)
  • Requires banks to maintain a sufficient stock of high-quality liquid assets (HQLA) to cover net cash outflows over a 30-day stress period
  • HQLA includes cash, central bank reserves, and certain government securities
  • Aims to ensure banks can withstand short-term liquidity shocks
• Net Stable Funding Ratio (NSFR)
  • Requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities
  • Promotes longer-term funding stability and reduces reliance on short-term wholesale funding
  • Calculated as the ratio of available stable funding (ASF) to required stable funding (RSF)
    • ASF includes capital, long-term liabilities, and stable deposits
    • RSF is based on the liquidity characteristics and residual maturities of assets and off-balance sheet exposures
• Monitoring tools and metrics
  • Contractual maturity mismatch to identify potential liquidity gaps
  • Concentration of funding to assess the reliance on particular funding sources
  • Available unencumbered assets to evaluate the availability of collateral for secured funding
  • Market-related monitoring to capture potential market liquidity risks

Impact on Banks and Financial Institutions

• Higher capital requirements lead to increased costs and reduced profitability in the short term
  • Need to raise additional capital through retained earnings, equity issuance, or deleveraging
  • Potential impact on lending capacity and credit availability
• Liquidity standards require banks to hold more high-quality liquid assets, which may have lower yields
  • Increased funding costs due to the need for stable, long-term funding sources
• Enhanced risk management and governance practices
  • Investments in risk management systems, processes, and personnel
  • Greater focus on stress testing, scenario analysis, and contingency planning
• Increased regulatory compliance costs
  • Adaptation of internal systems and processes to meet new reporting and disclosure requirements
  • Ongoing monitoring and assessment of compliance with Basel III standards
• Potential changes in business models and strategies
  • Re-evaluation of risk-return trade-offs and product offerings
  • Increased focus on core banking activities and reduced involvement in high-risk or capital-intensive businesses
• Improved financial stability and resilience
  • Better-capitalized and more liquid banks are better positioned to withstand economic shocks and market turbulence
  • Reduced risk of systemic crises and taxpayer-funded bailouts

Implementation Challenges and Criticisms

• Complexity and scope of the Basel III framework
  • Extensive and detailed requirements across multiple areas (capital, liquidity, leverage, risk management)
  • Challenges in interpreting and applying the rules consistently across jurisdictions
• Potential unintended consequences
  • Reduced lending capacity and credit availability, particularly for small and medium-sized enterprises (SMEs)
  • Shift towards lower-risk assets, potentially leading to a concentration of risks in certain sectors
  • Regulatory arbitrage and the migration of risks to the less-regulated shadow banking system
• Differences in implementation across jurisdictions
  • National discretions and variations in the adoption of Basel III standards
  • Potential for an unlevel playing field and regulatory fragmentation
• Procyclicality concerns
  • Risk-weighted capital requirements may amplify business cycle fluctuations
  • Countercyclical capital buffer aims to mitigate this, but its effectiveness remains to be seen
• Reliance on internal models for risk assessment
  • Potential for model risk and inconsistencies in risk-weighted asset calculations across banks
  • Efforts to enhance the comparability and robustness of internal models through the Fundamental Review of the Trading Book (FRTB) and other initiatives
• Ongoing calibration and refinement
  • Continuous monitoring and assessment of the impact and effectiveness of Basel III measures
  • Potential need for further adjustments and revisions based on implementation experiences and evolving risks

Future Outlook and Basel IV

• Full implementation of outstanding Basel III reforms
  • Fundamental Review of the Trading Book (FRTB) to be implemented by January 1, 2023
  • Revised credit valuation adjustment (CVA) risk framework
  • Revised operational risk framework (Standardized Measurement Approach)
  • Output floor to limit the variability of risk-weighted assets calculated using internal models
• Ongoing monitoring and assessment of Basel III impact and effectiveness
  • Regular quantitative impact studies (QIS) and monitoring reports by the BCBS
  • Evaluation of the cumulative effects of the reforms on the banking system and the broader economy
• Potential enhancements and revisions (informally referred to as "Basel IV")
  • Further refinements to the risk-weighted asset framework
  • Enhancements to the leverage ratio and liquidity standards
  • Increased focus on operational resilience and cyber risks
  • Greater harmonization and comparability of risk-weighted asset calculations across banks and jurisdictions
• Continued emphasis on proportionality and simplicity
  • Tailoring of regulatory requirements based on the size, complexity, and risk profile of banks
  • Efforts to reduce the compliance burden for smaller and less complex institutions
• Interaction with other regulatory initiatives and developments
  • Integration of sustainability and climate-related risks into the Basel framework
  • Alignment with the ongoing work on digital innovation, fintech, and crypto-assets
  • Coordination with other international standard-setting bodies and regulatory authorities