Basel III

Basel III is the third of three Basel Accords, a framework that sets international standards and minimums for bank capital requirements, stress tests, liquidity regulations, and leverage, with the goal of mitigating the risk of bank runs. It was developed in response to the deficiencies in financial regulation revealed by the 2007–2008 financial crisis and builds upon the standards of Basel II, introduced in 1984, and Basel I, introduced in 1988.

Basel III was published by the Basel Committee on Banking Supervision in November 2010, and was first scheduled to be introduced from 2013 until 2015; however, implementation was extended until 1 January 2023, due to the COVID-19 pandemic.

The Fundamental Review of the Trading Book (FRTB) and the Basel III: Finalising post-crisis reforms, which came into effect in January 2023, were deemed not substantial enough to warrant the title of "Basel IV" and the Basel Committee refer to only three Basel Accords.

Key principles

See also: Capital requirement, Capital adequacy ratio, and List of bank stress tests

CET1 capital requirements

${\frac {\mbox{CET1}}{\mbox{RWAs}}}=CET1ratio$

Basel III requires banks to have a minimum CET1 ratio (Common Tier 1 capital divided by risk-weighted assets (RWAs)) at all times of:

• 4.5%
  

Plus:

• A mandatory "capital conservation buffer" or "stress capital buffer requirement", equivalent to at least 2.5% of risk-weighted assets, but could be higher based on results from stress tests, as determined by national regulators.
  

Plus:

• If necessary, as determined by national regulators, a "counter-cyclical buffer" of up to an additional 2.5% of RWA as capital during periods of high credit growth. This must be met by CET1 capital.

It also requires minimum Tier 1 capital of 6% at all times (beginning in 2015).

Common Tier 1 capital comprises shareholders equity (including audited profits), less deductions of accounting reserve that are not believed to be loss absorbing "today", including goodwill and other intangible assets. To prevent the potential of double-counting of capital across the economy, bank's holdings of other bank shares are also deducted.

Leverage ratio

Leverage ratio is calculated by dividing Tier 1 capital by the bank's leverage exposure. The leverage exposure is the sum of the exposures of all on-balance sheet assets, 'add-ons' for derivative exposures and securities financing transactions (SFTs), and credit conversion factors for off-balance sheet items.

Basel III introduced a minimum leverage ratio of 3%. The requirement acts as a back-stop to the risk-based capital metrics.

${\frac {\mbox{Tier 1 Capital}}{\mbox{Total exposure}}}\geq 3\%$

For typical mortgage lenders that underwrite assets of a low risk weighting, the leverage ratio will often be the binding capital metric.

The U.S. Federal Reserve requires a minimum leverage ratio of 5% for U.S. banks, higher for systemically important financial institutions.

In the EU, the minimum bank leverage ratio is the same 3% as required by Basel III.

The UK requires a minimum leverage ratio, for banks with deposits greater than £50 billion, of 3.25%. This higher minimum reflects the PRA's differing treatment of the leverage ratio, which excludes central bank reserves in 'Total exposure' of the calculation.

Liquidity requirements

Basel III introduced two required liquidity/funding ratios.

• The "Liquidity coverage ratio", which requires banks to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days under a stressed scenario. This was implemented because some adequately-capitalized banks faced difficulties because of poor liquidity management. The LCR consists of two parts: the numerator is the value of HQLA, and the denominator consists of the total net cash outflows over a specified stress period (total expected cash outflows minus total expected cash inflows). Mathematically it is expressed as follows:

${\text{LCR}}={\frac {\text{High quality liquid assets}}{\text{Total net liquidity outflows over 30 days}}}\geq 100\%$

• The Net stable funding ratio requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

${\text{NSFR}}={\frac {\text{Available amount of stable funding}}{\text{Required amount of stable funding }}}>100\%$

Liquidity coverage ratio requirements for U.S. banks

In 2014, the Federal Reserve Board of Governors approved a U.S. version of the liquidity coverage ratio. The U.S. requirements are higher than the Basel III requirements based on the definitions of HQLA and total net cash outflows. Certain privately issued mortgage backed securities are included in HQLA under Basel III but not under the U.S. rule. Conds and securities issued by financial institutions, which can become illiquid during a financial crisis, are not eligible under the U.S. rule. The rule is also modified for banks that do not have at least $250 billion in total assets or at least $10 billion in on-balance sheet foreign exposure.

Counterparty risk: CCPs and SA-CCR

A new framework for exposures to CCPs was introduced in 2017.

The standardised approach for counterparty credit risk (SA-CCR), which replaced the Current exposure method, became effective in 2017. SA-CCR is used to measure the potential future exposure of derivative transactions in the leverage exposure measure and non-modelled Risk Weighted Asset calculations.

Equity investments in funds

Capital requirements for equity investments in hedge funds, managed funds, and investment funds were introduced in 2017. The framework requires banks to take account of a fund's leverage when determining risk-based capital requirements associated with the investment and more appropriately reflecting the risk of the fund's underlying investments, including the use of a 1,250% risk weight for situations in which there is not sufficient transparency.

Large exposures

A framework for limiting large exposure to external and internal counterparties was implemented in 2018.

In the UK, as of 2024, the Bank of England was in the process of implementing the Basel III framework on large exposures.

Securitisations

A revised securitisation framework, effective in 2018, aims to address shortcomings in the Basel II securitisation framework and to strengthen the capital standards for securitisations held on bank balance sheets. The frameworks addresses the calculation of minimum capital needs for securitisation exposures.

Interest rate risk in the banking book

New rules for interest rate risk in the banking book became effective in 2018. Banks are required to calculate their exposures based on "economic value of equity" (EVE) under a set of prescribed interest rate shock scenarios.

Market risk: FRTB

Further information: Fundamental Review of the Trading Book

Following a Fundamental Review of the Trading Book, minimum capital requirements for market risk in the trading book will be based on a better calibrated standardised approach or internal model approval (IMA) for an expected shortfall measure rather than, under Basel II, value at risk. The Basel Committee's oversight body, the Group of Central Bank Governors and Heads of Supervision (GHOS), announced in December 2017 that the implementation date of these reforms, which were originally set to be effective in 2019, was delayed to 1 January 2022. In March 2020, the implementation date was delayed to 1 January 2023.

Basel III: Finalising post-crisis reforms

Further information: Basel III: Finalising post-crisis reforms

The Basel 3.1 standards published in 2017 cover further reforms in six areas: standardised approach for credit risk (SA-CR); internal ratings based approach (IRB) for credit risk; CVA risk; operational risk; an output floor; and the leverage ratio. The GHOS announced in March 2020 that the implementation date of these reforms, which were originally set to be effective at the start of 2022, was delayed to 1 January 2023.

Implementation

Summary of originally-proposed changes (2010) in Basel Committee language

• First, the quality, consistency, and transparency of the capital base will be raised.
  • Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings. This is subject to prudential deductions, including goodwill and intangible assets.
  • Tier 2 capital: supplementary capital, however, the instruments will be harmonised.
  • Tier 3 capital will be eliminated.
• Second, the risk coverage of the capital framework will be strengthened.
  • Promote more integrated management of market and counterparty credit risk
  • Add the credit valuation adjustment–risk due to deterioration in counterparty's credit rating
  • Strengthen the capital requirements for counterparty credit exposures arising from banks' derivatives, repo and securities financing transactions
  • Raise the capital buffers backing these exposures
  • Reduce procyclicality and
  • Provide additional incentives to move OTC derivative contracts to qualifying central counterparties (probably clearing houses). Currently, the BCBS has stated derivatives cleared with a QCCP will be risk-weighted at 2% (The rule is still yet to be finalized in the U.S.)
  • Provide incentives to strengthen the risk management of counterparty credit exposures
  • Raise counterparty credit risk management standards by including wrong-way risk
• Third, a leverage ratio will be introduced as a supplementary measure to the Basel II risk-based framework.
  • intended to achieve the following objectives:
    • Set minimum leverage in the banking sector
    • Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures.
• Fourth, a series of measures is introduced to promote the buildup of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers").
  • Measures to address procyclicality:
    • Dampen excess cyclicality of the minimum capital requirement;
    • Promote more forward looking provisions;
    • Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and
  • Achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth.
    • Requirement to use long-term data horizons to estimate probabilities of default,
    • downturn loss-given-default estimates, recommended in Basel II, to become mandatory
    • Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements.
    • Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.
  • Promoting stronger provisioning practices (forward-looking provisioning):
    • Advocating a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).
• Fifth, a global minimum liquidity standard for internationally active banks is introduced that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued a statement saying that regulators will allow banks to dip below their required liquidity levels, the liquidity coverage ratio, during periods of stress.)
• The committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions. (See also Total Loss Absorbency Capacity.)

As of September 2010, proposed Basel III norms asked for ratios as: 7–9.5% (4.5% + 2.5% (conservation buffer) + 0–2.5% (seasonal buffer)) for common equity and 8.5–11% for Tier 1 capital and 10.5–13% for total capital.

Timing

On 15 April 2014, the Basel Committee on Banking Supervision (BCBS) released the final version of its "Supervisory Framework for Measuring and Controlling Large Exposures" (SFLE) that builds on longstanding BCBS guidance on credit exposure concentrations.

On 3 September 2014, the U.S. banking agencies (Federal Reserve, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation) issued their final rule implementing the Liquidity Coverage Ratio (LCR). The LCR is a short-term liquidity measure intended to ensure that banking organizations maintain a sufficient pool of liquid assets to cover net cash outflows over a 30-day stress period.

On 11 March 2016, the Basel Committee on Banking Supervision released the second of three proposals on public disclosure of regulatory metrics and qualitative data by banking institutions. The proposal requires disclosures on market risk to be more granular for both the standardized approach and regulatory approval of internal models.

In January 2013, the BCBS extended not only the implementation schedule to 2019, but broadened the definition of liquid assets.

In December 2017, the Basel Committee's oversight body, the Group of Central Bank Governors and Heads of Supervision (GHOS), extended the implementation of the market risk framework from 2019 to 1 January 2022. In March 2020, implementation of the Basel III: Finalising post-crisis reforms, the market risk framework, and the revised Pillar 3 disclosure requirements were extended by one year, to 1 January 2023.

US implementation

The US Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules. It summarized them as follows, and made clear they would apply not only to banks but also to all institutions with more than US$50 billion in assets:

• "Risk-based capital and leverage requirements" including first annual capital plans, conduct stress tests, and capital adequacy "including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions" – see scenario analysis on this. A risk-based capital surcharge
• Market liquidity, first based on the United States' own "interagency liquidity risk-management guidance issued in March 2010" that require liquidity stress tests and set internal quantitative limits, later moving to a full Basel III regime – see below.
• The Federal Reserve Board itself would conduct tests annually "using three economic and financial market scenarios". Institutions would be encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including company-specific information, would be made public" but one or more internal company-run stress tests must be run each year with summaries published.
• Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a single counterparty as a percentage of the firm's regulatory capital. Credit exposure between the largest financial companies would be subject to a tighter limit".
• "Early remediation requirements" to ensure that "financial weaknesses are addressed at an early stage". One or more "triggers for remediation—such as capital levels, stress test results, and risk-management weaknesses—in some cases calibrated to be forward-looking" would be proposed by the Board in 2012. "Required actions would vary based on the severity of the situation, but could include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales".
• In April 2020, in response to the COVID-19 pandemic, the Federal Reserve announced a temporary reduction of the Supplementary Leverage Ratio (applicable to financial institutions with more than $250 billion in consolidated assets) from 3% to 2%, effective until 31 March 2021. On 19 March 2021, the Federal Reserve announced that the year-long emergency relief would not be renewed at the end of the month.

European implementation

Main article: Capital Requirements Regulation and Directive

The implementing act of the Basel III agreements in the European Union has been the new legislative package comprising Directive 2013/36/EU (CRD IV) and Regulation (EU) No. 575/2013 on prudential requirements for credit institutions and investment firms (CRR).

The new package, approved in 2013, replaced the Capital Requirements Directives (2006/48 and 2006/49).

On 7 December 2017, ECB chief Mario Draghi declared that for the banks of the European Union, the Basel III reforms were complete.

Key milestones

Capital requirements

Date	Milestone: Capital requirement
2014	Minimum capital requirements: Start of the gradual phasing-in of the higher minimum capital requirements.
2015	Minimum capital requirements: Higher minimum capital requirements were fully implemented.
2016	Conservation buffer: Start of the gradual phasing-in of the conservation buffer.
2019	Conservation buffer: The conservation buffer was fully implemented.

Leverage ratio

Date	Milestone: Leverage ratio
2011	Supervisory monitoring: Developed templates to track the leverage ratio and the underlying components.
2013	Parallel run I: The leverage ratio and its components must be tracked by supervisors but not disclosed and not mandatory.
2015	Parallel run II: The leverage ratio and its components must be tracked and disclosed but not mandatory.
2017	Final adjustments: Based on the results of the parallel run period, any final adjustments to the leverage ratio.
2018	Mandatory requirement: The leverage ratio became a mandatory part of Basel III requirements.

Liquidity requirements

Date	Milestone: Liquidity requirements
2011	Observation period: Developed templates and supervisory monitoring of the liquidity ratios.
2015	Introduction of the LCR: Initial introduction of the Liquidity Coverage Ratio (LCR), with a 60% requirement. This will increase by ten percentage points each year until 2019. In the EU, 100% will be reached in 2018.
2018	Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR).
2019	LCR comes into full effect: 100% LCR.

Analysis of Basel III impact

Macroeconomic impact

An OECD study, released on 17 February 2011, estimated that the medium-term impact of Basel III implementation on GDP growth would be in the range of −0.05% to −0.15% per year. Economic output would be mainly affected by an increase in bank lending spreads, as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements originally effective in 2015 banks were estimated to increase their lending spreads on average by about 15 basis points. Capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy would no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.

In the United States, higher capital requirements resulted in contractions in trading operations and the number of personnel employed on trading floors.

Criticism

Basel III does not go far enough in reducing reliance on external credit rating agencies, notably Moody's Investors Service and Standard & Poor's, thus using public policy to strengthen anti-competitive duopolistic practices. The conflicted and unreliable credit ratings of these agencies is generally seen as a major contributor to the 2000s United States housing bubble.

Academics criticized Basel III for continuing to allow large banks to calculate credit risk using internal models and for setting overall minimum capital requirements too low.

Opaque treatment of all derivatives contracts is also criticized. While institutions have many legitimate ("hedging", "insurance") risk reduction reasons to deal in derivatives, the Basel III accords:

• treat insurance buyers and sellers equally even though sellers take on more concentrated risks (literally purchasing them) which they are then expected to offset correctly without regulation
• do not require organizations to investigate correlations of all internal risks they own
• do not tax or charge institutions for the systematic or aggressive externalization or conflicted marketing of risk—other than requiring an orderly unravelling of derivatives in a crisis and stricter record keeping

Since derivatives present major unknowns in a crisis these are seen as major failings by some critics causing several to claim that the "too big to fail" status remains with respect to major derivatives dealers who aggressively took on risk of an event they did not believe would happen—but did. As Basel III does not absolutely require extreme scenarios that management flatly rejects to be included in stress testing this remains a vulnerability.

The Heritage Foundation argued that capitalization regulation is inherently fruitless due to these and similar problems and—despite an opposite ideological view of regulation—agree that "too big to fail" persists.

Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework. Notwithstanding the enhancement introduced by the Basel III standard, it argued that "markets often fail to discipline large banks to hold prudent capital levels and make sound investment decisions".

In comments published in October 2012, the American Bankers Association, community banks organized in the Independent Community Bankers of America, and Democratic Senators Ben Cardin and Barbara Mikulski and Representatives Chris Van Hollen and Elijah Cummings of Maryland, said that the Basel III proposals would hurt small banks by increasing their capital holdings dramatically on mortgage and small business loans.

Robert Reich, former United States Secretary of Labor and Professor of Public Policy at the University of California, Berkeley, has argued that Basel III did not go far enough to regulate banks since, he believed, inadequate regulation was a cause of the 2007–2008 financial crisis and remains an unresolved issue despite the severity of the impact of the Great Recession.

In 2019, Michael Burry criticized Basel III for what he characterizes as "more or less remov[ing] price discovery from the credit markets, meaning risk does not have an accurate pricing mechanism in interest rates anymore."

The Institute of International Finance (IIF, a Washington, D.C.–based, 450-member banking trade association), argued against the implementation of the accords, claiming it would hurt banks and economic growth and add to the paper burden and risk inhibition by banks.

External links

• Basel III capital rules
• Basel III liquidity rules
• Bank Management and Control, Springer Nature – Management for Professionals, 2020
• U.S. Implementation of the Basel Capital Regulatory Framework Congressional Research Service
• Securitized Products Risk Charges: Going Beyond on SSFA Archived 8 March 2021 at the Wayback Machine
• Basel III in India
• How Basel III Affects SME Borrowing Capacity