Basel III

${\displaystyle {\frac {\mbox{CET1}}{\mbox{RWAs}}}={\mbox{CET1}}\;{\textrm {ratio}}}$

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.^[9]

In the U.S., an additional 1% is required for globally systemically important financial institutions.^[10]

It also requires minimum Tier 1 capital of 6% at all times (beginning in 2015).^[9]

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.

Tier 2 capital + Tier 1 capital is required to be above 8%.

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.^[11][12]

Basel III introduced a minimum leverage ratio of 3%.^[13]

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

The U.S. established another ratio, the supplemental leverage ratio, defined as Tier 1 capital divided by total assets. It is required to be above 3.0%.^[14] A minimum leverage ratio of 5% is required for large banks and systemically important financial institutions.^[15] Due to the COVID-19 pandemic, from April 2020 until 31 March 2021, for financial institutions with more than $250 billion in consolidated assets, the calculation excluded U.S. Treasury securities and deposits at Federal Reserve Banks.^[16][14][17]

In the EU, the minimum bank leverage ratio is the same 3% as required by Basel III.^[18]

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.^[19]

Basel III introduced two required liquidity/funding ratios.^[20]

The liquidity coverage ratio 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.^[21] 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).^[22] Mathematically it is expressed as follows:

${\displaystyle {\text{LCR}}={\frac {\text{High quality liquid assets}}{\text{Total net liquidity outflows over 30 days}}}\geq 100\%}$^[20][21]

Regulators can allow banks to dip below their required liquidity levels per the liquidity coverage ratio during periods of stress.^[23]

In 2014, the Federal Reserve Board of Governors approved a U.S. version of the liquidity coverage ratio,^[21] which had more stringent 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. Bonds 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.^[24]

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.

${\displaystyle {\text{NSFR}}={\frac {\text{Available amount of stable funding}}{\text{Required amount of stable funding }}}>100\%}$^[20]

A new framework for exposures to CCPs was introduced in 2017.^[13]

The standardised approach for counterparty credit risk (SA-CCR), which replaced the Current exposure method, became effective in 2017.^[13] 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.

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.^[25]

A framework for limiting large exposure to external and internal counterparties was implemented in 2018.^[13]

In the UK, as of 2024, the Bank of England was in the process of implementing the Basel III framework on large exposures.^[26]

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.^[27] The frameworks addresses the calculation of minimum capital needs for securitisation exposures.^[28][29]

Basel III reclassifies physical gold from a Tier 3 asset to a Tier 1 asset.

New standards for "interest rate risk in the banking book" (IRRBB) became effective in 2023. Banks are required to calculate their exposures based on "economic value of equity" (EVE) and "net interest income" (NII) under a set of prescribed interest rate shock scenarios.^[30][31] The standards thereby deal with the risks associated with a change in interest rates, including interest rate gaps, basis risk, yield curve risk, and option risk.^[32] The bank's exposure to IRRBB is then equal to the largest negative change in EVE across all scenarios - in essence, the theoretical risk to the economic value of a bank's equity from a change in interest rates.^[33] IRRBB falls under Pillar II.^[33]

Following a Fundamental Review of the Trading Book, minimum capital requirements for market risk in the trading book are 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.^[34]

The Basel III: Finalising post-crisis reforms standards cover further reforms in six areas:^[35]

• standardised approach for credit risk (SA-CR)
• internal ratings based approach (IRB) for credit risk
• Credit valuation adjustment risk (the process through which counterparty credit is valued, priced and hedged - using a standardised approach);
• Operational risk - A standardised approach for operational risk for a bank based on income and historical losses
• Output floor - Replaces Basel II output floor with a more robust risk-sensitive floor and disclosure requirements
• Finalised Leverage ratio framework - buffer for global systemically important banks, definitions and requirements, exposure measures for on-balance sheet exposures, derivatives, securities financing transactions and off-balance sheet items.

• The quality, consistency, and transparency of the capital base was 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 were harmonised.
  • Tier 3 capital was eliminated.^[36]
• The risk coverage of the capital framework was strengthened.
  • Promoted more integrated management of market and counterparty credit risk
  • Added the credit valuation adjustment–risk due to deterioration in counterparty's credit rating
  • Strengthened the capital requirements for counterparty credit exposures arising from banks' derivatives, repo and securities financing transactions
  • Raised the capital buffers backing these exposures
  • Reduced procyclicality and
  • Provided additional incentives to move OTC derivative contracts to qualifying central counterparties (probably clearing houses). Where a bank acts as a clearing member of a central counterparty for its own purposes, a risk weight of 2% must be applied to the bank’s trade exposure to the central counterparty.^[37]
  • Provided incentives to strengthen the risk management of counterparty credit exposures
  • Raised counterparty credit risk management standards by including wrong way risk
• A series of measures was 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;
    • Promoted more forward looking provisions;
    • Conserved capital to build buffers at individual banks and the banking sector that can be used in stress; and
  • Achieved 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 scenarios of widening yield spreads in recessions.
  • Stronger provisioning practices (forward-looking provisioning):
    • Advocates a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).^[38]

In the U.S., Basel III applies 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"
• 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.
• The Federal Reserve Board itself conducts stress tests annually using three economic and financial market scenarios. Institutions are encouraged to use at least five scenarios reflecting improbable events, and especially those considered impossible by management, but no standards apply to extreme scenarios. Only a summary of the three official Fed scenarios including company-specific information is 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 is 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. Required actions vary based on the severity of the situation, but include restrictions on growth, capital distributions, and executive compensation, as well as capital raising or asset sales.^[39]

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.^[40]

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.^[41]

In January 2013, the BCBS extended not only the implementation schedule to 2019, but broadened the definition of liquid assets.^[42]

In December 2017, the implementation of the market risk framework was delayed from 2019 to 2022.^[43] Implementation of the Basel III: Finalising post-crisis reforms, the market risk framework, and the revised Pillar 3 disclosure requirements were extended several times and will be phased-in by 2028.^[5]

The Federal Reserve implemented the Basel III standards in the U.S., with some modifications, via a proposal first published in 2011.^[45] Final rules on the liquidity coverage ratio were published in 2014.^[46]

The implementing act of the Basel III agreements in the European Union was Directive 2013/36/EU (CRD IV) and Regulation (EU) No. 575/2013 on prudential requirements for credit institutions and investment firms (CRR), which was approved in 2013 and replaced the Capital Requirements Directives (2006/48 and 2006/49).^[47][48][49]

An OECD study, released on 17 February 2011, projected that all else equal, the medium-term impact of Basel III implementation on economic growth would be in the range of −0.05% to −0.15% per year due to increased bank lending spreads of 15 to as much as 50 basis points. The study hypothesized that the effect can be negated by a decrease in monetary policy rates of 30 to 80 basis points^[50][51][52]

In June 2024, a study by PwC projected that implemented of the Basel III Endgame requirements would reduce economic growth in the U.S. by 56 basis points via reduced returns to bank shareholders and increased costs to consumers and businesses.^[53]

In the United States, higher capital requirements resulted in contractions in trading operations and the number of personnel employed on trading floors.^[54]

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.^[55]

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^[56] 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.^[57]

Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework.^[58] 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".^[58]

In comments published in October 2012, the American Bankers Association, community banks organized in the Independent Community Bankers of America, and Democratic Party 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.^{[59][60][61][62]}

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 2008 financial crisis and remains an unresolved issue despite the severity of the impact of the Great Recession.^[63]

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."^[64]

The Institute of International Finance 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.^[65]