What is Basel III

What is Basel III?

Following on from the 2008 Global Financial Crisis, Basel III was introduced into the financial markets. Basel III is a comprehensive set of reform measures developed by the Basel Committee on Banking Supervision (BCBS) to strengthen the regulation, supervision, and risk management of the banking sector.

It aimed to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, improve risk management and governance, and strengthen banks’ transparency and disclosures.

Understanding Basel III

Basel III was introduced in response to the deficiencies in financial regulation revealed by the financial crisis of 2007-2008. It built on the previous Basel I and Basel II frameworks and introduced more stringent regulatory standards for banks, including higher capital requirements and new regulatory requirements on bank liquidity and leverage.

Key Components of Basel III

There are a number of new metrics brought in by Basel III to further modify the risk-weightings and the overall risk faced by the banking sector.

Basel III Capital Requirements

Basel III increased the minimum capital requirements for banks. It introduced the Common Equity Tier 1 (CET1) ratio, which required banks to hold a higher percentage of their risk-weighted assets in the form of common equity.

Basel III Leverage Ratio

A non-risk-based leverage ratio was also introduced to serve as a backstop to the risk-based capital measures.

The Supplementary Leverage Ratio (SLR)

The Supplementary Leverage Ratio (SLR) is a regulatory standard that measures the leverage of a bank. It is calculated by dividing Tier 1 capital by the bank’s total leverage exposure. The SLR aims to limit the amount of leverage a bank can have, with larger banks facing more stringent requirements. The SLR’s denominator, Total Leverage Exposure, includes a balance sheet and some off-balance sheet items.

Supplementary Leverage Ratio (SLR) Formula:

The UK Leverage Ratio

The UK Leverage Ratio is calculated by dividing Tier 1 capital by the leverage exposure measure. This ratio aims to limit the amount of leverage a bank can have, with larger banks facing more stringent requirements.

UK Leverage Ratio Formula:

Basel III Liquidity Requirements

Basel III introduced two liquidity ratios – the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) – to ensure that banks have sufficient liquidity to withstand short-term and long-term stress.

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Implementation of Basel III

The implementation of Basel III was phased in over several years, with full implementation initially targeted for 2019. However, the timeline was extended to allow banks more time to meet the new requirements. National regulators are responsible for implementing Basel III in their respective jurisdictions, and the pace of implementation can vary across countries.

Basel Committee

The Basel Committee on Banking Supervision (BCBS) is an international committee formed to develop standards for banking regulation. It is the primary global standard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters. The committee’s mandate is to strengthen the regulation, supervision, and practices of banks worldwide to enhance financial stability

Impact of Basel III

Basel III has had a significant impact on the banking sector. It has led to higher capital and liquidity buffers, which have made banks more resilient to financial shocks. However, it has also increased the cost of banking, as banks need to hold more capital and maintain higher liquidity levels. This has led to concerns about the potential impact on lending and economic growth.

Criticisms of Basel III

Critics argue that Basel III’s higher capital and liquidity requirements could constrain banks’ ability to lend, potentially slowing economic growth. There are also concerns that the complexity of the new regulations will lead to increased compliance costs and that the reliance on risk-weighted assets could incentivize banks to engage in regulatory arbitrage.

Basel III vs. Basel I and II

Basel III was built on the frameworks established by Basel I and Basel II. Basel I introduced the concept of risk-weighted assets and minimum capital requirements. Basel II added more complex risk-weighting measures and introduced the three pillars of capital adequacy, supervisory review, and market discipline. Basel III further increased capital requirements, introduced new liquidity and leverage ratios, and aimed to address the shortcomings revealed by the financial crisis.

Other Important Regulations

Aside from Basel III, several other important regulations have a significant influence on the banking industry:

• Dodd-Frank Act (US): This is a significant piece of legislation affecting almost all parts of the US financial sector. It established new government agencies to oversee various components of the financial system.
• Volcker Rule (US): This rule prevents banks from using their funds for proprietary trading.
• MiFID (EU): The Markets in Financial Instruments Directive (MiFID) is a harmonized regulation governing trading venues that financial instruments are traded on.
• EMIR (EU): The European Market Infrastructure Regulation (EMIR) regulates over-the-counter (OTC) derivatives, central counterparties, and trade repositories.

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Conclusion

Basel III represented a significant step forward in strengthening the resilience of the banking sector. While it has increased the regulatory burden on banks, it has also made them more robust and better able to withstand financial shocks. The ongoing challenge will be to balance the need for financial stability with the need to support economic growth. Basel IV is built on the process made by the earlier Basel directives and aims to be fully implemented in 2025.