Basel III: An Essential Guide
Wondering what Basel III is? This guide will tell you everything you need to know about the Basel 3 Accord and Basel banking regulations. It will also cover history of the accords as well as its key principles.
What is Basel III? (What is Basel 3?)
Basel 3 is a set of international banking regulations developed by the Bank for International Settlements in order to promote stability in the international financial system. Basel III regulation is designed to decrease damage done to the economy by banks that take on too much risk.
Basel III was introduced following the 2008 Global Financial Crisisto to improve the banks’ ability to handle any shocks from financial stress and strengthen both their transparency and their disclosure. Basel III builds on the previous accords, Basel I and Basel II, and is part of a process to improve regulation in the banking industry.
History of the Basel Accords
The Basel Committee on Banking Supervision, also known as BCBS, was established in 1974 by the central bank governors of the Group of Ten, or G10, countries in response to disruptions in financial markets. The committee was created as a forum where member countries could discuss banking supervisory matters. The committee is responsible for ensuring financial stability by strengthening regulation, supervision, and banking practices around the world.
The committee was expanded in 2009 to 27 jurisdictions, including:
- The Netherlands
- Saudi Arabia
- Hong Kong
- South Africa
- United Kingdom
- United States
The BCBS reports to the Group of Governors and Heads of Supervision, also known as GHOS, is located in Basel, Switzerland, at the Bank for International Settlements, also known as BIS.
Since its creation, the committee has created the Basel I, Basel II, and Basel III accords. Members of the committee agreed on Basel III in November 2010 after issues with the original accord became evident during the banking crisis. Regulations were introduced from 2013 to 2015, but there have been several extensions to March 2019 and January 2022.
The Principles of Basel III
There are a few key principles, according to the Basel III summary:
Minimum Capital Requirements
The Basel III accord increased the minimum Basel III capital requirements for banks from 2% in Basel II to 4.5% of common equity, as a percentage of the bank’s risk-weighted assets. There is also an extra 2.5% buffer capital requirement that brings the total minimum requirement to 7% in order to be Basel compliant. Banks can use the buffer when they face financial stress, but using the buffer can lead to even more financial constraints when paying dividends.
In 2015, the Tier I capital requirement increased from 4% in Basel II to 6% in Basel III. The 6% includes 4.5% of Common Equity Tier 1 and an additional 1.5% of additional Tier 1 capital. The requirements were originally meant to be implemented starting in 2013, but banks now have until January 1, 2022, to implement the changes.
Basel III introduced a non-risk-based leverage ratio as a backstop to the risk-based capital requirements. Banks are required to hold a leverage ratio in excess of 3%, and the non-risk-based leverage ratio is calculated by dividing Tier 1 capital by the average total consolidated assets of a bank. The Federal Reserve Bank of the United States fixed the leverage ratio at 5% for insured bank holding companies, and at 6% for Systematically Important Financial Institutions (SIFI), in order to conform to the requirement.
Basel III introduced the use of two liquidity ratios, including the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The Liquidity Coverage Ratio mandates that banks hold sufficient highly liquid assets that can withstand a 30-day stressed funding scenario, specified by the supervisors. The mandate was introduced in 2015 at only 60% of its stated requirements and is expected to increase by 10% each year until 2019, when it takes full effect. The Net Stable Funding Ratio, also known as NSFR, mandates that banks maintain stable funding above the required amount of stable funding for a period of one year of extended stress.
Potential Effects of Basel III
Basel III should lead to a safer financial system while only slightly restraining future economic growth. The impact is likely to be diverse for investors, but Basel III should lead to safer markets for bond investors and more stability for stock market investors. A better understanding of Basel III regulations will enable investors to understand the financial sector moving forward while helping them formulate macroeconomic opinions on the stability of the international financial system and the world economy.
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