Due to the Covid-19 pandemic, the Basel Committee has recently postponed the final date for the adoption of Basel III regulations to January 2023. The delay gives the financial organisations extra time to adjust their processes to the big changes ahead.
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. You can learn more about the genesis of that crisis from this blog post: What is credit crunch and can data analytics prevent it?
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
- 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.
What does it mean 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 requires 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 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 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.
Basel III introduced two important liquidity ratios to ensure that banks have enough liquidity 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 lie mainly in their 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.
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.
What’s the deadline for adopting Basel III regulations?
Due to the Covid-19 pandemic, the implementation date of the Basel III standards has been delayed by one year – to January 1, 2023. In the UK the implementation is planned for post March 2023.
Long story short
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.