Demystifying Basel III – Part 2

Part 2 – Basel III enhancements over Basel II

Basel III represents an effort to fix the gaps and lacunae in Basel II (See previous part for a detailed discussion). However, it is very important to note that Basel III does not jettison Basel II but builds on the essence of Basel II i.e., the link between risk profiles of banks and their capital requirements. Therefore, Basel III is an enhancement of Basel II.

The enhancements in Basel III over Basel II come primarily in five areas:

  1. Raising the Level and Quality of Capital
  2. Introducing a Global Liquidity Standard
  3. Supplementing Risk-based Capital with Leverage Ratio
  4. Measures for addressing Systemic Risk
  5. Measures for reducing Pro-cyclicality

 

Let us now have a brief look at each of the five areas mentioned above.

1. Raising the Level and Quality of Capital

Once bitten twice shy – this principle has definitely worked and Basel III requires both better quality capital and higher amount of capital. Let us have a look at the capital requirements under Basel III and compare the same with Basel II:

As seen from the above table, the minimum capital the minimum capital requirement remains at 8% of Risk Weighted Assets (RWA) in Basel III. But, Basel III has introduced a Capital Conservation Buffer of 2.5% of RWA over and above the minimum capital requirement, raising the total capital requirement to 10.5% of RWA as against 8.0% of Basel II.

Capital Conservation Buffer: The Capital Conservation Buffer is stipulated to ensure that banks are able to absorb the losses without breaching the minimum capital requirement, and are able to carry on business even in a downturn without deleveraging. It is important to note that this buffer is not part of regulatory minimum. However, the level of this buffer would determine the discretionary payments such as dividends distributed to shareholders and bonuses paid to staff.

Countercyclical Capital Buffer: In addition to Capital Conservation Buffer, Basel III introduces another capital buffer known as the Countercyclical Capital Buffer. This is in the range of 0% to 2.5% of RWA. This buffer can be mandated by the regulator on banks during periods of excess credit growth.

In addition to these two buffers, Basel III also provides for higher capital surcharge on systemically important banks. There are also other prescriptions regarding quality of capital within the minimum total so that capital is able to absorb losses, and calling upon tax payers to bear the burden of bail-out becomes absolutely the last resort!

 

2. Introducing a Global Liquidity Standard

In order to mitigate liquidity risk, Basel III addresses both potential short term liquidity stress and longer term structural liquidity mismatches in banks balance sheets by introducing liquidity requirements as follows:

Liquidity Coverage Ratio (LCR) promotes short term resilience by requiring sufficient high quality liquid assets to survive significant liquidity stress scenario lasting for 1 month.

NSFR promotes resilience over longer term (1 year) through incentives for banks to fund activities with more stable sources of funding. The NSFR mandates a minimum amount of stable sources of funding relative to the liquidity profile of assets, as well as potential for contingent liquidity needs arising from off-balance sheet commitments over a one year horizon. In essence, NSFR is aimed at encouraging banks to exploit stable sources of funding.

3. Supplementing Risk Based Capital with Leverage Ratio

To mitigate the risk of banks building up excess leverage as happened under Basel II, Basel III institutes a leverage ratio as a back stop to the risk based capital requirement. The Basel Committee is contemplating a Tier 1 leverage ratio of  3% or 33.3 times Tier 1 Capital which will eventually become Pillar 1 requirement as of January 1, 2018.

4. Measures for addressing Systemic Risk

Basel III has prescribed measures for addressing systemic risk which includes the following:

  • Measures to reduce the probability and impact of failure of Systemically Important Financial Institutions (SIFIs) which includes capital and / or liquidity surcharges, risk based levies on non-core funding.
  • Measures to improve capacities to resolve  SIFIs such as Living Wills, Cross border resolution framework etc.
  • Introduction of Central Counterparties for derivative settlements

5. Measures for reducing Pro-cyclicality:

Apart from introduction of the concept of Countercyclical Capital Buffer, the measures for reducing pro-cyclicality includes requiring banks to align compensation schemes to long term  viability and promoting expected loss model in accounting framework.

The above measures are sought to be introduced in a phased manner and BIS has suggested a time frame starting from January 2013. Most of the central banks and regulators have already announced their plans for the introduction of the measures. The ultimate goal is a stable financial system facilitating steady economic growth.

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