What is Basel III?
Basel III is a regulatory framework, an extension in the Basel Accords, designed and agreed upon by the members of the Basel Committee on Banking Supervision to strengthen the capital requirements of banks and mitigate risk. This is done by requiring the banks to hold more capital reserves against their assets which would in turn reduce the capacity of banks to get leverage.
The Basel Committee on Banking Supervision was established in 1974 with the aim to ensure financial stability by making stringent regulations on banking practices and finances. The committee comprised of governors from central banks of ten different countries – headquartered in Basel, Switzerland.
The Basel committee initially consisted of the G10 members. Later in 2009, it expanded the membership to institutions from Brazil, Australia, India, Saudi Arabia, Russia, Japan, Italy, Mexico, Argentina, Canada, Belgium, Indonesia, Switzerland, South Africa, the United Kingdom, and the United States, all of which form.
Basel III introduced reforms that aimed to mitigate risk in the banking system. The objective behind the accord is to keep more security as a reserve before raising money. It is aimed at enhancing the banking regulatory framework that was prescribed in the earlier Basel accords. It emphasized improving the resilience of banks by considering financial and risk management with stress testing in extreme situations. It ensures the strengthening of banks during times of liquidity crisis and financial distressFinancial DistressFinancial Distress is a situation in which an organization or any individual is not capable enough to honor its financial obligations as a result of insufficient revenue. It is usually the result of high fixed costs, obsolete technology, high debt, improper planning and budgeting, and poor management, and it can eventually lead to insolvency or bankruptcy..
Basel III came into existence upon agreement by members of BCBS in November 2010. The implementation was scheduled from 2013 but suffered repeated extension in the rollout. The first scheduled for March 2019 while the second schedule is due in January 2022.
In the United States, Basel III has been said to be applicable to all institutions with assets over US$ 50 billion with differences in ratio requirements and calculations. In 2013, the Federal Reserve Board approved the U.S. version of the liquidity coverage ratio of the Basel III accord. The United States has also proposed the categorization of liquid assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet. in three levels with 0%, 20%, and 50% risk-weighting, with special importance given to the systematically important banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. .
In the European context, the scheduled imposition of capital requirements, leverage ratioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity., and liquidity requirements varied in time.
Basel III Pillars
- Requiring banks to maintain minimum capital reserve along with an additional layer of buffer in common equity.
- Stress testing the banking system by implementation of leverage requirements.
- Additional capital and liquidity requirements for systematically important banks.
Basel III Rules
- Capital reserveCapital ReserveCapital reserve is a reserve that is formed from the company's profits earned from its non-operating activities during a period of time and is retained for the purpose of financing the company's long-term projects or writing off its capital expenses in the future. requirements increased to 7%, including the capital of 2.5% buffer against risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement. (RWAs). Additional legislation requires a countercyclical buffer of 0% to 2.5% of RWAs for CET1
- It requires common equity funding of 4.5% for risk-weighted assets. In Basel II, this requirement was 2%
- Minimum Tier 1 capital increased from 4% in Basel II to 6% in Basel III, comprising of 4.5% of CET1 and an additional 1.5% of AT1 (Additional Tier 1)
- Banks must maintain a leverage ratio of at least 3%. That is the Tier 1 Capital should be at least 3% or more of the total consolidated assets (incl. non-balance sheet items)
- Banks required to hold high-quality liquid assets to cover total cash outflows over 30 days.
- Net Stable Funding Ratio requirement increased to an over a one-year period.
- Capital reserve requirements will reduce competition in the banking sector as the barriers to entry increase. Critics argue that stringer norms will shield the sector in adverse ways.
- Leverage and capital adequacy requirements will also impact efficiencies of bigger banks who have had consistent growths based on stable margins.
- The risk-weighting methodology is the same in Basel III to calculate RWAs as it was in Basel IIBasel IIBasel II is the second set of regulations concerning Minimum Capital Requirement, Supervisory Review, Role and Market Discipline, and Disclosure. The Basel Committee on Bank Supervision developed the regulations for international banks in order to ensure a transparent and risk-free banking environment.. This might give importance to rating agencies that rate assets based on riskiness. Critics argue that such reliance on rating agencies is troublesome at least after the 2008 subprime crisis.
- Basel III criticism is not limited to its principles and regulations but also the implementation.
- Critics have repeatedly underscored the delay in implementation of the framework.
- American Bankers Association criticized the regulation stating that Basel III would not only impact but cripple the smaller banks in the United States.
Stringent Basel II norms will certainly make an impact on the ease of business that banks around the globe enjoy. The tightened requirements of the capital buffer, leverage, and liquidity will hit the profitability and margins of the banks. For example, a higher capital requirement of 7% introduced in Basel III will cut banks’ profits to some extent. The size of loan disbursements will be directly affected by the capital reserve requirement.
An OECD (Organization for Economic Cooperation and Development) study in 2011 showed that the effect of Basel III on GDP would be -0.05% to -0.015% annually in the medium-term. Another study showed that banks had to increase an estimated 15 basis pointsBasis PointsBasis points or BPS is the smallest unit of bonds, notes and other financial instruments. BPS determines the slightest change in interest rate, to be precise. One basis point equals 1/100th part of 1%. on their lending spreads to meet the requirements of the capital reserve rule.
Basel III is arguable a good step in strengthening the banking environment after the global financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors. in 2008. The crisis showed that bigger banks are eyeing rapid expansion without giving due weightage to riskier lending. The result was a pressing need for a stricter framework that could regulate leverage, liquidity, and capital buffer within the sector.
It was introduced with revisions and strength to the principles of Basel II. The new framework prescribes higher capital adequacy with respect to RWAs, capital conservation buffers, and countercyclical buffer with respect to RWAs, thus emphasizing strengthening the international banking system.
However, it has certain weaknesses that expose the sector to inefficiencies. It was widely accepted, and implementation was carried out across the globe. However, harmonization of banking regulations around the world can also lead to deteriorating results as some countries already have better frameworks.
This has been a guide to what is Basel III. Here we discuss objectives, implementation, pillars, and rules of Basel III along with criticism and impact. You may learn more about financing from the following articles –