A framework for establishing global norms for bank capital adequacy, stress testing, and liquidity needs.
The third Basel Accord, or Basel III, is a framework for establishing global norms for bank capital adequacy, stress testing, and liquidity needs.
It was created in response to the flaws in financial regulation exposed by the financial crisis of 2007–2008, augmenting and overriding certain Basel II rules.
By raising the minimum capital requirements, ownership of high-quality liquid assets, and lowering bank leverage, it aims to increase bank capital needs.
The Basel Committee on Banking Supervision published Basel III in November 2010, intending to implement it between 2013 and 2015. However, in the wake of the COVID-19 epidemic, implementation was twice postponed until 1 January 2022 and then again until 1 January 2023.
Sometimes known as Basel IV, the new regulations that took effect in January 2023 include the Fundamental Review of the Trading Book (FRTB) and Basel 3.1: Finalizing Post-Crisis Reforms.
In contrast, the Basel Committee's secretary general stated in a speech in 2016 that he did not think the modifications were significant enough to merit the term, and the Basel Committee only referred to the three Basel Accords.
The over-leveraged and under-capitalized state of the banks contributed to the financial crisis.
Many banks lacked the reserve liquidity necessary to support their significant exposure to the real estate industry. Therefore, following the crisis, it was implemented to limit the riskiness of a bank's balance sheet by requiring certain capital, leverage, and liquidity ratios.
The summary cites the following fundamental ideas:
1. Capital Minimum Requirements
The Basel III accord increased the minimum capital requirements for banks from 2% under Basel II to 4.5% of common stock as a percentage of the bank's risk-weighted assets.
To be Basel compliant, an organization must have a minimum capital ratio of 7% plus a buffer capital requirement of 2.5%. Banks may use the buffer when facing financial difficulties, but doing so might lead to even tighter financial constraints regarding dividend payments.
2. Countercyclical Interventions
2015 saw a rise in the Tier I capital requirement from 4% to 6%. The 6% comprises 1.5% additional Tier 1 capital and 4.5% more Tier 1 common equity. Instead of starting in 2013, as originally anticipated, banks waited until 1 January 2022 to complete the changes.
3. Leverage Ratio
This Basel incorporated a non-risk-based leverage ratio as a backup to the risk-based capital requirements. A bank's average total consolidated assets divided by its Tier 1 capital yields the non-risk-based leverage ratio, which banks must keep and be higher than 3%.
The Federal Reserve Bank of the United States established the leverage ratio at 5% for insured bank holding companies and 6% for Systemically Important Financial Institutions (SIFI) to comply with the rule.
4. Requirements for Liquidity
This makes accessible the Liquidity Coverage Ratio and the Net Stable Funding Ratio as two liquidity metrics.
To comply with the Liquidity Coverage Ratio, banks must keep a sufficient amount of highly liquid assets on hand to get through a financial crunch that lasts 30 days, as the authorities decide.
The requirement will reportedly increase by 10% per year until it is completely executed in 2019, having first been adopted in 2015 with just 60% of its stated conditions met.
According to the Net Stable Financing Ratio, or NSFR, banks must maintain stable funding above the required level over a year of extended difficulty.
Basel III's Potential Impact
Basel III should result in a more secure financial system while only modestly limiting future economic development. The impact on investors is likely to be varied, but the guidelines should result in safer markets for bond investors and more stability for stock market investors.
A greater grasp of this Basel laws will assist investors in comprehending the financial sector in the future and making macroeconomic judgments on the soundness of the international financial system and the global economy.
Basel III's purpose is to strengthen regulation, supervision, and risk management in the global banking industry and rectify the shortcomings of Basel I and Basel II, which were exposed during the subprime mortgage debacle and financial crisis of 2007-2008.
The Organization for Economic Cooperation and Development (OECD) estimated in 2011 that those guidelines would have a medium-term effect on GDP of -0.05% to -0.15% yearly. Banks will need to raise lending margins to remain viable, and they will do so by passing those increases along to their clients.
The introduction of this Basel will impact the derivatives markets since more clearing brokers will leave the market owing to increased costs.
Basel III capital rules aim to lower counterparty risk, which varies depending on whether the bank trades with a dealer or a central clearing counterparty (CCP).
Basel III intends to remedy some of the regulatory flaws identified in Basel I and Basel II during the 2007-2008 financial crisis. It is expected to be fully implemented by 2028.
If a bank joins a derivative trade with a dealer, Basel III generates a liability and imposes a significant capital penalty.
Conversely, trading derivatives through a CCP incurs only a 2% fee, making it more appealing to banks. The departure of dealers would concentrate risks among fewer members, making it difficult to shift trades from one bank to another and raising the systemic risk.
The LCR bias toward banks keeping government bonds and covered bonds will reduce demand for secularized assets and lower-quality corporate bonds.
As a result, banks will store more liquid assets and a higher share of long-term obligations to avoid maturity mismatch and maintain a low NSFR. Banks will also reduce the number of commercial operations that are more vulnerable to liquidity issues.
The Institute of International Finance, a 450-member banking trade organization based in the United States, objected to the adoption of Basel III because it may harm banks and limit economic development.
According to the OECD assessment, the guidelines would reduce yearly GDP growth by 0.05 to 0.15%.
In addition, the American Bankers Association in the United States Congress worried that this Basel would kill small U.S. banks by boosting their capital holdings on mortgage and SME loans.
Basel III is the third of the Basel Accords and a series of worldwide banking reforms. It was established by the Basel Committee on Banking Supervision, situated in Switzerland, and is composed of central banks worldwide, including the Federal Reserve of the United States.
These guidelines have considerably enhanced regulation. The agreement has led to increased capital requirements, the introduction of liquidity restrictions, and the establishment of standards for governance and compensation in countries worldwide.
This will lessen the possibility of bank failure. And so will initiatives to improve oversight.
Supervisors are becoming more proactive and forward-thinking in significant jurisdictions worldwide, monitoring banks and preventing banks from reaching the point of non-viability.
Supervisors ensure that banks maintain a capital cushion that would allow them to survive a major downturn in economic conditions, which is where stress testing comes into play.
This has sped up banks' adherence to Basel III's stricter capital requirements. In conclusion, stricter oversight has accompanied stricter regulation. Together, they lessen the possibility of banks failing.
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Researched and authored by Arnav Chaudhary | Linkedin
Reviewed and edited by Parul Gupta | LinkedIn
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