What is Basel III?
Basel III (or the Third Basel Accord or Basel Standards) is a global, voluntary regulatory framework on bank capital adequacy, stress testing, and market liquidity risk. This third installment of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage. Basel III was agreed upon by the members of the Basel Committee on Banking Supervision in November 2010, and was scheduled to be introduced from 2013 until 2015; however, implementation was extended repeatedly to 31 March 2019.
Also referred to as the Third Basel Accord, Basel III is part of a continuing effort to enhance the international banking regulatory framework that began in 1975. It builds on the Basel I and Basel II accords in an effort to improve the banking system’s ability to deal with financial stress, improve risk management, and promote transparency. On a more granular level, Basel III seeks to strengthen the resilience of individual banks to reduce the risk of system-wide shocks and prevent future economic meltdowns.
In October 2013, the Federal Reserve Board proposed rules to implement the Liquidity Coverage Ratio in the United States, which would strengthen the liquidity positions of large financial institutions. The proposal would create for the first time standardized minimum liquidity requirements for large and internationally active banking organizations and systemically important, non-bank financial companies designed by the Financial Stability Oversight Council. These institutions would be required to hold minimum amounts of high-quality, liquid assets such as central bank reserves and government and corporate debt that can be converted quickly and easily into cash.
In July 2013, the Federal Reserve Board finalized a rule to implement Basel III capital rules in the United States, a package of regulatory reforms developed by the BCBS. The comprehensive reform package is designed to help ensure that banks maintain strong capital positions that will enable them to continue lending to creditworthy households and businesses even after unforeseen losses and during severe economic downturns. This final rule increases both the quantity and quality of capital held by U.S. banking organizations. The Board also published the Community Banking Organization Reference Guide, which is intended to help small, non-complex banking organizations navigate the final rule and identify the changes most relevant to them.
The Basel III reforms have now been integrated into the consolidated Basel Framework, which comprises all of the current and forthcoming standards of the Basel Committee on Banking Supervision.
Portions of the Basel III agreement have already gone into effect in certain countries. The rest are currently set to begin implementation on Jan. 1, 2023, and to be phased in over five years.
Principles of Basel III
- Minimum Capital Requirements Under Basel III: Banks have two main silos of capital that are qualitatively different from one another. Tier 1 refers to a bank’s core capital, equity, and the disclosed reserves that appear on the bank’s financial statements. If a bank experiences significant losses, Tier 1 capital provides a cushion that can allow it to weather stress and maintain a continuity of operations. By contrast, Tier 2 refers to a bank’s supplementary capital, such as undisclosed reserves and unsecured subordinated debt instruments. Tier 1 capital is more liquid and considered more secure than Tier 2 capital. A bank’s total capital is calculated by adding both tiers together. Under Basel III, the minimum total capital ratio that a bank must maintain is 8% of its risk-weighted assets (RWAs), with a minimum Tier 1 capital ratio of 6%. The rest can be Tier 2. While Basel II also imposed a minimum total capital ratio of 8% on banks, Basel III increased the portion of that capital that must be in the form of Tier 1 assets, from 4% to 6%. Basel III also eliminated an even riskier tier of capital, Tier 3, from the calculation.
- Capital Buffers for Tough Times: Basel III introduced new rules requiring that banks maintain additional reserves known as countercyclical capital buffers—essentially a rainy day fund for banks. These buffers, which may range from 0% to 2.5% of a bank’s RWAs, can be imposed on banks during periods of economic expansion. That way, they should have more capital at the ready during times of economic contraction, such as a recession, when they face greater potential losses. So, considering both the minimum capital and buffer requirements, a bank could be required to maintain reserves of up to 10.5%. Countercyclical capital buffers must also consist entirely of Tier 1 assets.
- Countercyclical Measures: In 2015, the Tier I capital requirement increased from 4% in Basel II to 6% in Basel III. The 6% includes 4.5% of Common Equity Tier 1 and an additional 1.5% of additional Tier 1 capital. The requirements were originally meant to be implemented starting in 2013, but banks now have until January 1, 2022, to implement the changes.
- Leverage and Liquidity Measures: Basel III likewise introduced new leverage and liquidity requirements aimed at safeguarding against excessive and risky lending, while ensuring that banks have sufficient liquidity during periods of financial stress. In particular, it set a leverage ratio for so-called “global systemically important banks.” The ratio is computed as Tier 1 capital divided by the bank’s total assets, with a minimum ratio requirement of 3%. In addition, Basel III established several rules related to liquidity. One, the liquidity coverage ratio, requires that banks hold a “sufficient reserve of high-quality liquid assets (HQLA) to allow them to survive a period of significant liquidity stress lasting 30 calendar days.” HQLA refers to assets that can be converted into cash quickly, with no significant loss of value. Another liquidity-related provision is the net stable funding (NSF) ratio, which compares the bank’s “available stable funding” (essentially capital and liabilities with a time horizon of more than one year) with the amount of stable funding that it is required to hold based on the liquidity, outstanding maturities, and risk level of its assets. A bank’s NSF ratio must be at least 100%. The goal of this rule is to create “incentives for banks to fund their activities with more stable sources of funding on an ongoing basis” rather than load up their balance sheets with “relatively cheap and abundant short-term wholesale funding.”
Impact and Criticisms of Basel III
The requirement that banks must maintain a minimum capital amount of 7% in reserve will make banks less profitable. Most banks will try to maintain a higher capital reserve to cushion themselves from financial distress, even as they lower the number of loans issued to borrowers. They will be required to hold more capital against assets, which will reduce the size of their balance sheets.
A study by the Organization for Economic Cooperation and Development (OECD) in 2011 revealed that the medium-term effect of Basel III on GDP would be -0.05% to -0.15% annually. To stay afloat, banks will be forced to increase their lending spreads as they pass the extra cost on to their customers.
The introduction of new liquidity requirements, mainly the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), will affect the operations of the bond market. To satisfy LCR liquid-asset criteria, banks will shy away from holding high run-off assets such as Special Purpose Vehicles (SPVs) and Structured Investment Vehicles (SIVs).
The demand for secularized assets and lower-quality corporate bonds will decrease due to the LCR bias toward banks holding government bonds and covered bonds. As a result, banks will hold more liquid assets and increase the proportion of long-term debts, in order to reduce maturity mismatch and maintain minimum NSFR. Banks will also minimize business operations that are more subject to liquidity risks.
The implementation of Basel III will affect the derivatives markets, as more clearing brokers exit the market due to higher costs. Basel III capital requirements focus on reducing counterparty risk, which depends on whether the bank trades through a dealer or a central clearing counterparty (CCP). If a bank enters into a derivative trade with a dealer, Basel III creates a liability and requires a high capital charge for that trade.
On the contrary, derivative trade through a CCP results in only a 2% charge, making it more attractive to banks. The exit of dealers would consolidate risks among fewer members, thereby making it difficult to transfer trades from one bank to another and increase systemic risk.
The Institute of International Finance, a 450-member banking trade association located in the United States, protested the implementation of Basel III due to its potential to hurt banks and slow down economic growth. The study by OECD revealed that Basel III would likely decrease annual GDP growth by 0.05 to 0.15%.
Also, the American Bankers Association and a host of Democrats in the U.S. Congress argued against the implementation of Basel III, fearing that it would cripple small U.S. banks by increasing their capital holdings on mortgage and SME loans.
Securing Data in Compliance with Basel III
Complying with Basel III, and the Basel Committee on Banking Supervision (BCBS) rule 239 ‘Principles for effective risk data aggregation and risk reporting’ creates a profound data management challenge for Global Systemically Important Banks and Domestically Systemically Important Banks alike. Basel III ups that ante for the velocity and breadth of data to drive risk models.
First, risk models must have more and better-quality risk data. Second, banks need to roll up and report on risk data from systems within hours rather than days or longer.
Data masking helps shield sensitive business and personal information, thus reducing the risk of non-compliance with Basel III. Banks can deliver this masked data anywhere, across departments, third parties, and cloud providers, without elevating risk, running afoul of Basel III, or raising the risk of a data breach.