Basel III definition

What is Basel 3?

Basel III is a set of agreements which contains suggestions for new regulations for the banking sector. Following the 2007 subprime crisis, the FSB (Financial Stability Board) and the 2010 G20 in Seoul contributed to the development of new stability measures for the world banking system.

Analysis of the crisis' effects found that its impact on banks came from banks' balance sheet and off-balance sheet figures growing too quickly together with low quality capital bases. The capital base is meant to cover risks, which is why banks need to increase its quality given the level of risk taken by them and their interdependencies.

The Financial Stability Board spearheaded Basel 3

Basel III context

Basel III was announced in 2010, but some measures of this agreement lack clarity. Basel III's requirements will have an impact on banks' strategy and activity. These requirements should lead to better stability, a necessity in the opinion of the public who are very attentive to banking activity as a result of the impact of the financial crisis on worsening the world economy.

Basel III model

Basel III is structured around three key areas and their subsequent influences. Basel III can be outlined as follows:

The main measures of Basel III

1- Better quality capital base

One of the objectives of Basel III is that in the event of bank losses, they are better protected, by increasing the quality of the capital base.  Banks will have to:

• Increase the share of Tier 1 Common equity, which is equivalent to ordinary shares, and reserves (which means increasing balances brought forward).
• Banks must deduct minority interests, shareholdings in other banks and deferred tax assets from Tier 1.
• Standardise Tier 2 on the balance sheet.
• Reduction and exclusion of financial product hybrids covered by common equity

These measures will lead to an increased capital base and a restriction of dividend distribution for banks, particularly because of the increase in retained earnings. Banks are encouraged to issue products convertible into shares to ensure that the capital base can be increased as soon as its level is too low.

2- Higher capital base levels

It was noted that the capital base level of banks were too low during the 2007 crisis. Basel III proposes to increase the capital base level as well as its quality by introducing new rules:

• Tier 1 (Common equity)

• More stringent "Core tier One" ratio: from 2% to 4.5%
• New 2.5% buffer (planned for 2019)
• Common equity level fixed at a minimum of 7% (objective for 2019)

• Total capital base:

• More demanding solvency ratio: from 8% to 10.5% (capital conservation buffer included)
• Creation of another buffer for countercyclical sector risk exposure

These new measures should urge banks to part from eligible assets in the capital base and to aim for higher levels of "Core tier One" solvency and ratios to maintain attractive distribution policies.

3- Reducing leverage under Basel III

Basel III's objective is to limit banks' balance sheet growth. Leverage is defined as the ratio between the capital base and total exposure. The new measures related to this point are:

• Leverage ratio fixed at 3% of Tier 1: Exposure cannot then be 33 times higher than Tier 1.

• The project started in 2013
• Ratio to be established by 2018

This measure is likely to lead to credit constraints and therefore a reduction to financing the economy. Banks are also likely to aim for more and more demanding levels for this leverage ratio, to obtain good evaluations from credit rating agencies and the overall market.

4- Better liquidity management

Long-term liquidity

The Basel III project intended to create a net stable funding ratio (NSFR) to encourage banks to find stable financing resources. This measure involves taking certain criteria into account:

• Rating different asset profiles and associating them with their recommended levels of stable resources (in function of their risks)
• New asset weightings require a certain level of funding (in function of their associated risks):

• Between 0% and 5% for cash and securities accounts
• Between 65% and 85% for loans to individuals and mortgages
• 100% for all other assets

This weighting can be seen as a level at which an asset must be funded using stable resources:

• New weighting in the quality of financing (by function of their stability):

• 100% for the Common Equity
• 80% to 90% for customer deposits
• 50% for low collateral or unsecured loans

This weighting can be seen as the maximum level to which these resources can finance an asset. This section assesses the stability of resources.

This measure should lead banks having more diversified funding so they are not dependent on one particular type of resource.

Banks will have to evaluate the stability of their resources in the balance sheet, by percentage and each asset's individual financing requirement.

Short-term liquidity

Basel III provides for the establishment of a liquidity coverage ratio (LCR) with an acceptable minimum limit of 100%. The aim is to improve banks' short term solvency. This measure requires banks to:

• Protect themselves against unanticipated, stressful situations by having good quality, liquid assets, enabling them to withstand cash outflows for at least 30 days.
• Risk-weigh assets on the basis of their quality and liquidity

Banks are going to be steered into investing in high quality assets, but with lower profitability so they can respond to the 30 day solvency requirement.

5- Systemic risk coverage in Basel III

Basel III requires an increase in the capital base level, so that banks' trading books are better covered (trading books are the set of tools and financial products held in the framework of negotiation or coverage of other products) particularly in the event of a future crisis.

The measures envisaged are:

• Redefinition of stressed VaR (measurement tool for a bank's portfolio market risk) with the incorporation of a capital charge
• Addition of additional capital charges to meet exposures to default risks and those of asset deterioration
• Force banks to go through clearing houses for transactions related to derivatives
• Incorporation of basis risk between financial institutions and therefore of contagion between them

Banks should be urged to limit transaction volumes with other banks and other financial institutions. In addition, the counterparty risk associated with derivatives should be better controlled. Therefore, there should be a global change to banks' trading books.