Basel 3: Basel III is part of the continuous effort to enhance the banking regulatory framework. It builds on the Basel I and Basel II documents, and seeks to improve the banking sector’s ability to deal with financial stress, improve risk management, and strengthen the banks’ transparency.
Basel III introduced tighter capital requirements in comparison to Basel I and Basel II. Banks’ regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because security instruments included in Tier 1 capital have the highest level of subordination. Common Equity Tier 1 capital includes equity instruments that have discretionary dividends and no maturity, while additional Tier 1 capital comprises securities that are subordinated to most subordinated debt, have no maturity and their dividends can be cancelled at any time. Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years.
In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed as a percent of risk-weighted assets. In particular, Basel III increased minimum Common Equity Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall regulatory capital was left unchanged at 8%.
Basel 3 measures aim to:
- Improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source
- Improve risk management and governance
- Strengthen banks’ transparency and disclosures.
Thus we can say that Basel III guidelines are aimed at to improve the ability of banks to withstand periods of economic and financial stress as the new guidelines are more stringent than the earlier requirements for capital and liquidity in the banking sector.
The basic structure of Basel III remains unchanged with three mutually reinforcing pillars.
Pillar 1 – Minimum Regulatory Capital Requirements: Minimum Regulatory Capital Requirements based on Risk Weighted Assets (RWAs) requires, maintaining the capital calculated through credit, market and operational risk areas.
Pillar 2 – Supervisory Review Process: Regulating tools and frameworks for dealing with peripheral risks that banks face.
Pillar 3 – Market Discipline: Increasing the disclosures that banks must provide to increase the transparency of banks
Major Changes Proposed:
Better Capital Quality: One of the key elements of Basel 3 is the introduction of much stricter definition of capital. Better quality capital means the higher loss-absorbing capacity. This in turn will mean that banks will be stronger, allowing them to better withstand periods of stress.
Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be required to hold a capital conservation buffer of 2.5%. The aim of asking to build conservation buffer is to ensure that banks maintain a cushion of capital that can be used to absorb losses during periods of financial and economic stress.
Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical buffer has been introduced with the objective to increase capital requirements in good times and decrease the same in bad times. The buffer will slow banking activity when it overheats and will encourage lending when times are tough i.e. in bad times. The buffer will range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.
Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for common equity, the highest form of loss-absorbing capital, has been raised under Basel III from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement, consisting of not only common equity but also other qualifying financial instruments, will also increase from the current minimum of 4% to 6%. Although the minimum total capital requirement will remain at the current 8% level, yet the required total capital will increase to 10.5% when combined with the conservation buffer.
Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many assets fell quicker than assumed from historical experience. Thus, now Basel III rules include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of capital to total assets (not risk-weighted). This aims to put a cap on swelling of leverage in the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a mandatory leverage ratio is introduced in January 2018.
Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created. A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be introduced in 2018.
Systemically Important Financial Institutions (SIFI): As part of the macro-prudential framework, systemically important banks will be expected to have loss-absorbing capability beyond the Basel III requirements. Options for implementation include capital surcharges, contingent capital and bail-in-debt.