Basel III is the third of three Basel Accords, a framework that sets international standards and minimums for bank capital requirements, stress tests, liquidity regulations, and leverage, with the goal of mitigating the risk of bank runs and bank failures. It was developed in response to the deficiencies in financial regulation revealed by the 2008 financial crisis and builds upon the standards of Basel II, introduced in 2004, and Basel I, introduced in 1988. The Basel III requirements were published by the Basel Committee on Banking Supervision in 2010, and began to be implemented in major countries in 2012. Implementation of the Fundamental Review of the Trading Book (FRTB), published and revised between 2013 and 2019, has been completed only in some countries and is scheduled to be completed in the United Kingdom and the European Union in 2027 and 2028 and is still subject to public comment in the United States. Implementation of the Basel III: Finalising post-crisis reforms (also known as Basel 3.1 or Basel III Endgame), introduced in 2017, is being phased in by countries between 2026 and 2028.
Key principles and requirements
Common Equity Tier 1 (CET1) capital requirements
CET1 RWAs = CET1 ratio {\displaystyle {\frac {\mbox{CET1}}{\mbox{RWAs}}}={\mbox{CET1}}\;{\textrm {ratio}}}
Basel III requires banks to have a minimum CET1 ratio (Common Tier 1 capital divided by risk-weighted assets (RWAs)) at all times of:
4.5% Plus:
A mandatory "capital conservation buffer" or "stress capital buffer requirement", equivalent to at least 2.5% of risk-weighted assets, but could be higher based on results from stress tests, as determined by national regulators. Plus:
If necessary, as determined by national regulators, a "counter-cyclical buffer" of up to an additional 2.5% of RWA as capital during periods of high credit growth. This must be met by CET1 capital. In the U.S., an additional 1% is required for globally systemically important financial institutions. It also requires minimum Tier 1 capital of 6% at all times (beginning in 2015). Common Tier 1 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.
Tier 2 capital requirements Tier 2 capital + Tier 1 capital is required to be above 8%.
Leverage ratio requirements Leverage 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. Basel III introduced a minimum leverage ratio of 3%.
Tier 1 Capital Total exposure ≥ 3 % {\displaystyle {\frac {\mbox{Tier 1 Capital}}{\mbox{Total exposure}}}\geq 3\%}
The U.S. established another ratio, the supplemental leverage ratio, defined as Tier 1 capital divided by total assets. It is required to be above 3.0%. A minimum leverage ratio of 5% is required for large banks and systemically important financial institutions. Due to the COVID-19 pandemic, from April 2020 until 31 March 2021, for financial institutions with more than $250 billion in consolidated assets, the calculation excluded U.S. Treasury securities and deposits at Federal Reserve Banks. In the EU, the minimum bank leverage ratio is the same 3% as required by Basel III. The UK requires a minimum leverage ratio, for banks with deposits greater than £50 billion, 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.
Liquidity requirements Basel III introduced two required liquidity/funding ratios.
Liquidity coverage ratio The liquidity coverage ratio requires banks to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days under a stressed scenario. This was implemented because some adequately-capitalized banks faced difficulties because of poor liquidity management. 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). Mathematically it is expressed as follows:
LCR = High quality liquid assets Total net liquidity outflows over 30 days ≥ 100 % {\displaystyle {\text{LCR}}={\frac {\text{High quality liquid assets}}{\text{Total net liquidity outflows over 30 days}}}\geq 100\%}
Regulators can allow banks to dip below their required liquidity levels per the liquidity coverage ratio during periods of stress.
Liquidity coverage ratio requirements for U.S. banks In 2014, the Federal Reserve Board of Governors approved a U.S. version of the liquidity coverage ratio, which had more stringent definitions of HQLA and total net cash outflows. Certain privately issued mortgage backed securities are included in HQLA under Basel III but not under the U.S. rule. Bonds and securities issued by financial institutions, which can become illiquid during a financial crisis, are not eligible under the U.S. rule. The rule is also modified for banks that do not have at least $250 billion in total assets or at least $10 billion in on-balance sheet foreign exposure.
Net stable funding ratio
The Net stable funding ratio requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress.
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