Basel 3

Basel 3 in five rules

Case study

Basel 3 is the third set of recommendations about the regulation of the banking system issued by the Basel Committee on Banking Supervision. This third version of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the 2008 financial crisis.

Basel 3 maintains the same three pillars approach than Basel II (capital requirements, supervisory review and market discipline) but introduces five major changes, mainly in terms of capital requirement and liquidity.

Basel 3 should be enforced at national level in several steps, from 2013 to 2019.

Change 1: more stringent definition of capital

The first major change introduced by Basel III is the clarification of the various definitions of equity given by the previous Basel Accords. As part of this clarification process, the new point of focus when calculating a bank’s RWAs ceased to be the sum of Tier 1 and Tier 2 capital to become only a sub-part of Tier 1, i.e. common equity tier 1 (CET1). CET1 represents a bank’s core capital and includes only share capital, share premium and retained earnings.

In other words, Basel 3 reduces the items that can be seen as capital. The expected consequence is to incentivize banks to increase their core capital.

Change 2: increase in capital requirements

If the minimum of total capital requirement (tier 1 + tier 2) remains just like in Basel 1 and 2 equal to 8% of total RWAs, the minimum of capital requirements of common equity tier 1 (CET1) increases dramatically.

The minimum common equity tier one for banks is increased by 2,5%, from 2% to 4,5% of a bank’s total RWAs. The banks are also required to have an additional 2,5% conservation buffer (mandatory equity calculated to absorb losses in stress scenarios) and a 0 to 2,5% countercyclical buffer (the value of this buffer is set by local regulators). On top of that, the Financial Stability Board requires that 29 Global systemic important banks (i.e. the 29 largest banks in the world) have to maintain a third buffer of 1% to 2.5% in common equity only. In other words, it means that, with Basel 3, some banks will be required to increase their common equity tier one capital from 2% to 9,5% of their total RWAs (for a regular bank) and even 12% (for the 29 Global systemic important bank).

Change 3: higher capital charges for some risks

In order to minimize the exposure of the banks to certain types of assets seen as too illiquid or too risky, Basel III has increased the capital charge required for these assets (especially for derivatives or OTC products).

Change 4: introduction of a risk insensitive ratio

Basel III requires the banks to maintain a 3% non-risk based leverage ratio, meaning that the banks cannot have a ratio of common equity tier one/total off and on-balance sheet exposure lower than 3%. This ratio is supposed to limit the total leverage of a bank, whatever its risk profile is.

Change 5: new liquidity ratios

In order to avoid a new Northern Rock or Lehman Brothers-type of bankruptcy, two new mandatory liquidity ratios are introduced, the LCR and the NSFR:
– The liquidity Coverage Ratio (LCR) ensures that sufficient high quality liquid resources are available for one month survival in case of a stress scenario. To comply with this ratio, the banks have to prove that the liquid assets they hold at any moment are higher than their cash outflows for 30 days. The ratio can be therefore read as follows: (liquid assets/cash outflows for the next 30 days) > 1.
– The Net Stable Funding Ratio (NSFR) creates additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis. As a consequence, they have to maintain the following ratio: (long term stable funding/weighted long term assets) > 1