Basel Framework International regulatory standards for banks |
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Background |
Pillar 1: Regulatory capital |
Pillar 2: Supervisory review |
Pillar 3: Market disclosure |
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Basel III is the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements. Augmenting and superseding parts of the Basel II standards, it was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to strengthen bank capital requirements by increasing minimum capital requirements, holdings of high quality liquid assets, and decreasing bank leverage.
Basel III was published by the Basel Committee on Banking Supervision in November 2010, and was scheduled to be introduced from 2013 until 2015; however, implementation was extended repeatedly to 1 January 2022 and then again until 1 January 2023, in the wake of the COVID-19 pandemic. [1] [2] [3] [4]
The new standards that come into effect in January 2023, that is, the Fundamental Review of the Trading Book (FRTB) and the Basel III: Finalising post-crisis reforms, are sometimes referred to as Basel IV. However, the secretary general of the Basel Committee said, in a 2016 speech, that he did not believe the changes are substantial enough to warrant that title and the Basel Committee refer to only three Basel Accords. [5] [6]
Basel III aims to strengthen the requirements in the Basel II regulatory standards for banks. In addition to increasing capital requirements, it introduces requirements on liquid asset holdings and funding stability, thereby seeking to mitigate the risk of a run on the bank.
The original Basel III rule from 2010 required banks to fund themselves with 4.5% of Common Equity Tier 1 (CET1) (up from 2% in Basel II) of risk-weighted assets (RWAs). Since 2015, a minimum CET1 ratio of 4.5% must be maintained at all times by the bank. [7] This ratio is calculated as follows:
The minimum Tier 1 capital increases from 4% in Basel II to 6%, [7] applicable in 2015, over RWAs. [8] This 6% is composed of 4.5% of CET1, plus an extra 1.5% of Additional Tier 1 (AT1).
CET1 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.
Furthermore, Basel III introduced two additional capital buffers:
Basel III introduced a minimum "leverage ratio" from 2018 based on a leverage exposure definition published in 2014. A revised exposure definition and a buffer for globally systemically important banks (G-SIBs) will be effective from 2023. [9]
The 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. [10] [11] The ratio acts as a back-stop to the risk-based capital metrics. The banks are expected to maintain a leverage ratio in excess of 3% under Basel III.
For typical mortgage lenders, who underwrite assets of a low risk weighting, the leverage ratio will often be the binding capital metric.
In 2013, the U.S. Federal Reserve announced that the minimum Basel III leverage ratio would be 5% for eight systemically important financial institution (SIFI) banks and 6% for their insured bank holding companies. [12] In the EU, whilst banks have been required to disclose their leverage ratio since 2015, a binding requirement has not yet been implemented. The UK operates its own leverage ratio regime, with a binding minimum requirement for banks with deposits greater than £50bn 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.
Basel III introduced two required liquidity/funding ratios. [13]
In 2013, the Federal Reserve Board of Governors approved an interagency proposal for the U.S. version of the Basel Committee on Banking Supervision (BCBS)'s Liquidity Coverage Ratio (LCR). The ratio would apply to certain U.S. banking organizations and other systemically important financial institutions. [15]
The United States' LCR proposal came out significantly tougher than BCBS's version, especially for larger bank holding companies. [16] The proposal requires financial institutions and FSOC designated nonbank financial companies [17] to have an adequate stock of high-quality liquid assets (HQLA) that can be quickly liquidated to meet liquidity needs over a short period of time.
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). [18]
The Liquidity Coverage Ratio applies to U.S. banking operations with assets of more than $10 billion. The proposal would require:
The US proposal divides qualifying HQLAs into three specific categories (Level 1, Level 2A, and Level 2B). Across the categories, the combination of Level 2A and 2B assets cannot exceed 40% HQLA with 2B assets limited to a maximum of 15% of HQLA. [18]
The proposal requires that the LCR be at least equal to or greater than 1.0 and includes a multiyear transition period that would require: 80% compliance starting 1 January 2015, 90% compliance starting 1 January 2016, and 100% compliance starting 1 January 2017. [20]
Lastly, the proposal requires both sets of firms (large bank holding companies and regional firms) subject to the LCR requirements to submit remediation plans to U.S. regulators to address what actions would be taken if the LCR falls below 100% for three or more consecutive days.
A new framework for exposures to CCPs was introduced in 2017. [9]
The standardised approach for counterparty credit risk (SA-CCR), which replaced the Current Exposure Method, became effective in 2017. [9] 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 funds were introduced in 2017. [9]
A framework for limiting large exposure to external and internal counterparties was implemented in 2018. [9]
A revised securitisation framework was introduced, which took effect in 2018. [9]
New rules for interest rate risk in the banking book became effective in 2018. [9]
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. [21] 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. [22] In March 2020, the implementation date was delayed to 1 January 2023. [23]
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. [24] 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. [23]
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. [28]
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. [29]
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). [30] 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. [31]
The US Federal Reserve announced in December 2011 that it would implement substantially all of the Basel III rules. [32] 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:
As of January 2014, the United States has been on track to implement many of the Basel III rules, despite differences in ratio requirements and calculations. [38]
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). [39]
The new package, approved in 2013, replaced the Capital Requirements Directives (2006/48 and 2006/49). [40]
On 7 December 2017, ECB chief Mario Draghi declared that for the banks of the European Union, the Basel III reforms were complete. [41]
Date | Milestone: Capital requirement |
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2014 | Minimum capital requirements: Start of the gradual phasing-in of the higher minimum capital requirements. |
2015 | Minimum capital requirements: Higher minimum capital requirements are fully implemented. |
2016 | Conservation buffer: Start of the gradual phasing-in of the conservation buffer. |
2019 | Conservation buffer: The conservation buffer is fully implemented. |
Date | Milestone: Leverage ratio |
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2011 | Supervisory monitoring: Developing templates to track the leverage ratio and the underlying components. |
2013 | Parallel run I: The leverage ratio and its components will be tracked by supervisors but not disclosed and not mandatory. |
2015 | Parallel run II: The leverage ratio and its components will 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 will become a mandatory part of Basel III requirements. |
Date | Milestone: Liquidity requirements |
---|---|
2011 | Observation period: Developing 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. [42] |
2018 | Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR). |
2019 | LCR comes into full effect: 100% LCR is expected. |
In the United States higher capital requirements resulted in contractions in trading operations and the number of personnel employed on trading floors. [43]
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. [44] [45] [46] 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.[ citation needed ] 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. [44]
Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework. [47] 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". [47]
Think tanks such as the World Pensions Council have argued that Basel III merely builds on and further expands the existing Basel II regulatory base without fundamentally questioning its core tenets, notably the ever-growing reliance on standardized assessments of "credit risk" marketed by two private sector agencies- Moody's and S&P, thus using public policy to strengthen anti-competitive duopolistic practices. [48] [49] The conflicted and unreliable credit ratings of these agencies is generally seen as a major contributor to the US housing bubble. Academics have 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. [50]
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:
Since derivatives present major unknowns in a crisis these are seen as major failings by some critics [51] 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.
A few critics argue 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. [52]
Basel III has been criticized similarly for its paper burden and risk inhibition by banks, organized in the Institute of International Finance, an international association of global banks based in Washington, D.C., who argue that it would "hurt" both their business and overall economic growth. Basel III was also criticized as negatively affecting the stability of the financial system by increasing incentives of banks to game the regulatory framework. [53] The American Bankers Association, [54] community banks organized in the Independent Community Bankers of America, and others voiced opposition to Basel III in their comments to the Federal Deposit Insurance Corporation, [55] saying that the Basel III proposals, if implemented, would hurt small banks by increasing "their capital holdings dramatically on mortgage and small business loans". [56]
Former US Secretary of Labor and Professor of Economics at the University of California, Berkeley Robert Reich has argued that Basel III did not go far enough to regulate banks since, he believed, inadequate regulation was a cause of the global financial crisis [57] and remains an unresolved issue despite the severity of the impact of the Great Recession. [58] In 2019, American investor 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." [59]
Before the enactment of Basel III in 2011, 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. The American Banker's Association, [60] community banks organized in the Independent Community Bankers of America, and some of the most liberal Democrats in the U.S. Congress, including the entire Maryland congressional delegation with Democratic Sens. Cardin and Mikulski and Reps. Van Hollen and Cummings, voiced opposition to Basel III in their comments submitted to FDIC, [55] saying that the Basel III proposals, if implemented, would hurt small banks by increasing "their capital holdings dramatically on mortgage and small business loans." [61]
In January 2013 the global banking sector won a significant easing of Basel III rules, when the BCBS extended not only the implementation schedule to 2019, but broadened the definition of liquid assets. [62] 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. [63] 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. [64]
The Basel Accords refer to the banking supervision accords issued by the Basel Committee on Banking Supervision (BCBS).
Banking regulation and supervision refers to a form of financial regulation which subjects banks to certain requirements, restrictions and guidelines, enforced by a financial regulatory authority generally referred to as banking supervisor, with semantic variations across jurisdictions. By and large, banking regulation and supervision aims at ensuring that banks are safe and sound and at fostering market transparency between banks and the individuals and corporations with whom they conduct business.
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is now extended and partially superseded by Basel III.
A capital requirement is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and risk becoming insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets. Capital is a source of funds not a use of funds.
Financial risk management is the practice of protecting economic value in a firm by managing exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as listed aside. As for risk management more generally, financial risk management requires identifying the sources of risk, measuring these, and crafting plans to mitigate them. See Finance § Risk management for an overview.
Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves, but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. This part of the Tier 1 capital will be phased out during the implementation of Basel III.
Basel I is the first Basel Accord. It arose from deliberations by central bankers from major countries during the late 1970s and 1980s. In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum capital requirements for banks. It is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992.
Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations.
Exposure at default or (EAD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. It can be defined as the gross exposure under a facility upon default of an obligor.
Asset and liability management is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.
Valuation risk is the risk that an entity suffers a loss when trading an asset or a liability due to a difference between the accounting value and the price effectively obtained in the trade.
Risk-weighted asset is a bank's assets or off-balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. In the Basel I accord published by the Basel Committee on Banking Supervision, the Committee explains why using a risk-weight approach is the preferred methodology which banks should adopt for capital calculation:
During the financial crisis of 2007–2008, several banks, including the UK's Northern Rock and the U.S. investment banks Bear Stearns and Lehman Brothers, suffered a liquidity crisis, due to their over-reliance on short-term wholesale funding from the interbank lending market. As a result, the G20 launched an overhaul of banking regulation known as Basel III. In addition to changes in capital requirements, Basel III also contains two entirely new liquidity requirements: the net stable funding ratio (NSFR) and the liquidity coverage ratio (LCR).
A systemically important financial institution (SIFI) is a bank, insurance company, or other financial institution whose failure might trigger a financial crisis. They are colloquially referred to as "too big to fail".
Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the internal ratings-based (IRB) approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.
Basel III: Finalising post-crisis reforms, sometimes called the Basel III Endgame, Basel 3.1 or Basel IV, are changes to international standards for bank capital requirements that were agreed by the Basel Committee on Banking Supervision (BCBS) in 2017 and are due for implementation in January 2023. They amend the international banking standards known as the Basel Accords.
The Capital Requirements Regulation(EU) No. 575/2013 is an EU law that aims to decrease the likelihood that banks go insolvent. With the Credit Institutions Directive 2013 the Capital Requirements Regulation 2013 reflects Basel III rules on capital measurement and capital standards.
An X-Value Adjustment is an umbrella term referring to a number of different “valuation adjustments” that banks must make when assessing the value of derivative contracts that they have entered into. The purpose of these is twofold: primarily to hedge for possible losses due to other parties' failures to pay amounts due on the derivative contracts; but also to determine the amount of capital required under the bank capital adequacy rules. XVA has led to the creation of specialized desks in many banking institutions to manage XVA exposures.
Liquidity regulations are financial regulations designed to ensure that financial institutions have the necessary assets on hand in order to prevent liquidity disruptions due to changing market conditions. This is often related to reserve requirement and capital requirement but focuses on the specific liquidity risk of assets that are held.
The standardized approach for counterparty credit risk (SA-CCR) is the capital requirement framework under Basel III addressing counterparty risk for derivative trades. It was published by the Basel Committee in March 2014. See Basel III: Finalising post-crisis reforms.
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(help)Tier 3 will be abolished to ensure that market risks are met with the same quality of capital as credit and operational risks.
...the set of international banking rules that have had the single largest impact require banks to hold capital as a buffer against trading losses—rules broadly referred to as Basel III.
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(help)American Bankers Association, the Securities Industry and Financial Markets Association and The Financial Services Roundtable respond to Basel III and other regulations