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 distress.
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.
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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 assets in three levels with 0%, 20%, and 50% risk-weighting, with special importance given to the systematically important banks and financial institutions.
In the European context, the scheduled imposition of capital requirements, leverage ratio, 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 reserve requirements increased to 7%, including the capital of 2.5% buffer against risk-weighted assets (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 II. 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 points 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 crisis 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 –