The key facts you should know about Basel III

Basel III is a comprehensive set of financial reforms developed by the Basel Committee on Banking Supervision (BCBS) in response to the 2008 global financial crisis. The framework introduces stricter minimum capital requirements, enhanced liquidity rules and standards, and more rigorous stress tests to ensure that banks are better equipped to absorb economic shocks without jeopardising the wider financial system.

From this article, you’ll find out what is Basel III, what’s coming with it, why it’s been introduced onto the international banking scene and how it will impact the financial sector. 

What is Basel III? 

Basel III is the third instalment of Basel Accords – a set of regulatory standards that aims at improving the regulation, supervision and risk management in the global banking sector.  

The overarching goal of Basel III regulations is to minimise possible damage to the economy caused by banks taking on a too high risk. In fact, the idea for introducing Basel Accords was developed as a response to the financial crisis of 2007-2008 sparked mainly by predatory lending and excessive risk-taking by international financial institutions.

The Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision (BCBS) is a global standard-setter for banking regulation. It brings together central banks and supervisory authorities from major economies to strengthen regulation, supervision, and banking practices worldwide.

Set up in 1974 by the central bank governors of the G10 countries, it currently has 45 members from 28 jurisdictions and applies to the UK, US, and EU banks, among others. The committee’s main aim is to improve financial stability, reduce operational risk, and boost the bank’s resilience to economic shocks. It doesn’t enforce rules itself but sets common standards – such as the Basel III framework – that national authorities then implement.

What’s different with Basel III?  

To strengthen the resilience of individual banks, Basel III introduced three key principles: higher capital requirements, new leverage ratio and liquidity standards. 

Increased capital requirements for banking sector  

• Common Equity Tier 1 must be at least 4.5% of risk-weighted assets of all times.  
• Tier 1 capital must be at least 6% of risk-weighted assets at all times.  
• Total capital (constituted of both Tier 1 capital and Tier 2 capital) must be at least 8% of risk-weighted assets at all times.  
• Additionally, a Common Equity Conservation buffer is set at 2.5% of risk-weighted assets for all banks. Also, banks may be subject to a countercyclical capital buffer requirement.  

Basel III minimum capital requirements in simple words  

Tier 1 capital is a bank’s core capital and exists as a primary source of its funds. It ensures that a bank has adequate reserves to survive financial losses. From the regulatory perspective, Tier 1 capital is the core measure of a bank’s strength. Basel III’s emphasis on Tier 1 capital is part of a broader risk-based capital framework aimed at ensuring banks have sufficient reserves to cover unexpected financial losses.

Basel III requires major banks to have enough of that capital so as to be able to cover unexpected financial losses and keep their ability to pay in case of another financial crisis. The rule is simple: the required minimum capital is correlated with the risk of assets – the higher the risk, the more capital a bank needs to have. Additionally, the buffer works as a financial cushion that banks can use in times of financial stress.

What is more, Basel III tightened up the requirements for large banks. The introduction of a countercyclical capital conservation buffer means that banks must save extra capital during times of credit expansion. The requirements are eased during periods of credit contraction in the credit cycle.

New “leverage ratio” requirement 

Basel III established a minimum leverage ratio of 3% that banks are expected to maintain. It’s calculated as the relation between Tier 1 capital and a bank’s average total consolidated assets.  

The UK has its own leverage ratio requirements, with a binding minimum requirement of 3.25% for banks with deposits greater than £50bn. The higher minimum results from a different treatment of the leverage ratio, which according to the Prudential Regulation Authority should exclude central bank reserves in the “total exposure” of the calculation.  

The leverage ratio serves as an indicator of how well prepared a bank is to undertake long-term financial liabilities. The main goal of the new leverage ratio requirement under Basel III is to protect banks against excessive and uncontrolled lending.  

Liquidity requirements for the banking sector 

Basel III introduced two important liquidity ratios (The Liquidity Coverage Ratio and Net Stable Funding Ratio) to ensure that banks follow liquidity requirements and have enough funds to survive periods of financial stress and are safeguarded against excessive borrowing. 

The first one, The Liquidity Coverage Ratio (LCR), requires banks to hold sufficient liquid assets that can cover 30-day net cash outflows under a stressed financial scenario.  First it was set at 60%, but since 2018 it was increased to 100%.  

Another liquidity ratio introduced by Basel III is the Net Stable Funding Ratio (NSFR). It requires banks to hold sufficient stable funding to exceed the required amount of stable funding over one year of financial stress.

What are the differences between Basel III vs Basel I and Basel II? 

The key differences between Basel III and its predecessors, Basel I and Basel II, mainly concern their banking regulation goals. In simple terms:

• Basel I focused solely on credit risk and was revolutionary as it set the ground for addressing risk management from a bank’s capital perspective.

• Basel II gave rise to a risk-sensitive approach to capital calculation and introduced a three-pillar approach to risk management. It focused on various risks, such as operational and strategic risk and increased supervisory responsibilities to normalize risk identification reporting.

• Basel III, as we’ve already explained, focuses on liquidity risk, considers macroeconomic factors alongside individual bank criteria and mandates requirements for higher minimum capital and additional buffer to be maintained.

Additionally, Basel III introduced a revised market risk framework to better assess and manage market risks faced by financial institutions.

What’s the impact of Basel III?  

Basel III regulations will undoubtedly have a good influence on global financial sector stability as they fill in all the gaps in the international regulatory framework, where Basel II fell short. However, the reform has sparked a certain degree of wariness in the banking industry as it may cause overleveraged and smaller banks to tighten up credit conditions for SMBs and start-ups.  

Long story short Basel III standards 

All three Basel accords, but especially Basel III, were introduced to better manage risks associated with banking in the modern world, where all banks are mutually interrelated. The key goal of Basel III is to improve the stability of the financial sector, strengthen individual banks for the turbulence in the financial markets and, from a wider perspective, avoid global financial catastrophes, like the 2007-2008 crisis.  

If you have more questions or want to ensure compliance with these evolving regulations, consult with our financial expert. It can help you navigate the complexities of Basel III, strengthen your risk management strategies, and secure your financial operations against future uncertainties.

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