The document outlines the Basel Committee's reforms aimed at strengthening global capital and liquidity rules to promote a more resilient banking sector. These reforms aim to enhance the banking sector's ability to absorb economic and financial shocks while reducing the risk of spillover to the real economy. The Basel III framework also includes measures to improve risk management, governance, and transparency of…
Title: Basel III: A global regulatory framework for more resilient banks and banking systems
Author: Basel Committee on Banking Supervision
Year: 2011 (December 2010, revised June 2011)
Type: international regulatory standard
Scope: global regulatory framework to strengthen the resilience of banks and banking systems, covering capital requirements, liquidity risk management, reduction of procyclicality, systemic risk management, and transitional requirements. Target population: international banks and banking supervisory authorities. Sector: global banking sector. Period: progressive implementation starting in 2011, with observation and application of ratios until 2018 (p. 1-19).
The Basel III document presents a global regulatory framework intended to strengthen the resilience of banks and banking systems worldwide, in response to weaknesses revealed by the 2007-2008 financial crisis (p. 9-10). The main objective is to improve banks' capacity to absorb financial and economic shocks, thereby reducing contagion risks to the real economy.
The main identified weaknesses are: insufficient quality of capital, excessive on- and off-balance sheet leverage, insufficient risk coverage, inadequate liquidity management, strong procyclicality of capital requirements, and high systemic interconnectedness among financial institutions (p. 9-16).
To address these, Basel III strengthens the quality and quantity of capital, emphasizing Common Equity Tier 1 capital with strict eligibility criteria. It introduces a simple leverage ratio complementing risk-based requirements, aimed at limiting excessive indebtedness (p. 10-13, 20-26).
The framework improves risk coverage, notably by strengthening requirements for counterparty exposures related to derivatives, complex securitisation activities, and reducing reliance on external ratings (p. 11-14).
Basel III also introduces macroprudential measures to reduce procyclicality, such as capital conservation buffers, a countercyclical buffer to address excessive credit growth, and provisions to limit contagion effects linked to interconnected systemic banks (p. 13-16).
A major component concerns liquidity risk management, establishing two harmonized international ratios: the Liquidity Coverage Ratio (LCR) to ensure short-term liquidity over 30 days, and the Net Stable Funding Ratio (NSFR) to guarantee a stable funding structure over a one-year horizon (p. 16-19).
The document provides transitional periods for the progressive implementation of new standards, allowing banks to strengthen capital without compromising economic financing (p. 18).
In conclusion, Basel III aims to create a stronger, more transparent banking system capable of withstanding financial shocks, combining microprudential and macroprudential requirements. It recommends rigorous and coordinated international application, with continuous monitoring of impacts on markets and the economy (p. 9-19).
The document was developed in response to the global financial crisis starting in 2007, which highlighted major weaknesses in international banking regulation, notably insufficient high-quality capital, inadequate liquidity risk management, and strong procyclicality of capital requirements (p. 9).
The stakes are high: the banking system is central to financial intermediation, and its failure can cause massive credit contraction and a global economic crisis. The crisis revealed that banks had accumulated excessive leverage, significant off-balance sheet exposures, and insufficient liquidity buffers, leading to widespread loss of confidence and costly public interventions (p. 9-10).
The objective is to strengthen banks' resilience to financial and economic shocks by improving the quality and quantity of capital, better covering risks, introducing measures to limit procyclicality, and establishing harmonized international liquidity standards (p. 9-19).
The scope covers international banks supervised by Basel Committee member authorities, with a globally applicable framework integrating microprudential (bank-level) and macroprudential (system-level) measures (p. 9-19).
Limitations include focusing on the first 31 pages of the document, covering fundamental principles and main requirements, without detailing annexes and some more advanced technical aspects.
Capital framework strengthening:
- Capital quality is improved by prioritizing Common Equity Tier 1, mainly composed of common shares and retained earnings, with strict eligibility criteria (p. 10-14, 20-26).
- Other capital categories (Additional Tier 1 and Tier 2) are harmonized with precise criteria, notably on subordination, perpetuity, and loss absorption capacity (p. 14-19).
- Regulatory deductions notably concern goodwill, intangible assets, deferred tax assets dependent on future profitability, holdings in financial entities, and treasury shares (p. 29-33).
Risk coverage improvement:
- Strengthening requirements for counterparty risk related to derivatives, introducing stress period requirements and valuation risk (CVA) consideration (p. 11-14).
- Encouragement to use central counterparties (CCPs) to reduce systemic risk and associated capital requirements (p. 11-14).
- Reduction of reliance on external ratings, with requirements for internal assessments and limitation of cliff effects (p. 14).
Leverage ratio:
- Introduction of a simple, risk-unweighted leverage ratio complementing risk-based requirements, to limit excessive indebtedness and provide protection against modelling errors (p. 12-13).
Procyclicality reduction and countercyclical buffers:
- Implementation of a capital conservation buffer to limit distributions during stress periods and support capital rebuilding (p. 13-15).
- Introduction of a countercyclical buffer activatable by national authorities to address excessive credit growth (p. 15).
- Promotion of forward-looking provisioning practices based on expected loss, supporting better loss management (p. 14).
Liquidity risk management:
- Establishment of the Liquidity Coverage Ratio (LCR) ensuring banks hold sufficient high-quality liquid assets to withstand a 30-day liquidity stress (p. 16-17).
- Establishment of the Net Stable Funding Ratio (NSFR) aiming to ensure a stable funding structure over a one-year horizon, limiting reliance on short-term funding (p. 17-18).
- Implementation of harmonized monitoring tools to assess liquidity, including maturity mismatch measurement, funding source concentration, unencumbered assets, and currency monitoring (p. 18).
Transitional arrangements:
- Progressive implementation of new standards with observation periods (LCR from 2011, application from 2015; NSFR observation then application from 2018) to limit negative impacts on economic financing (p. 18).
Scope of application:
- The framework applies according to principles defined in Basel II, covering internationally supervised banks and banking groups (p. 19).
Established facts:
- The financial crisis revealed insufficient high-quality capital, strong procyclicality of capital requirements, excessive leverage, and inadequate liquidity risk management (p. 9-10).
- The definition of capital is clarified and strengthened, with a strict hierarchy of components (Common Equity Tier 1, Additional Tier 1, Tier 2) and precise regulatory deductions (p. 20-33).
- The introduction of the leverage ratio provides a simple and transparent measure to limit overall indebtedness (p. 12-13).
- Liquidity requirements are now harmonized internationally with binding ratios (LCR, NSFR) (p. 16-19).
Assumptions:
- Improving capital quality and limiting leverage will reduce the probability of bank failure during stress periods.
- Implementing countercyclical buffers will moderate credit cycles and mitigate procyclical effects.
Interpretations:
- Combining microprudential and macroprudential measures is essential to strengthen banking system stability and limit systemic risks (p. 9-16).
- International harmonization of standards prevents competitive distortions and race-to-the-bottom dynamics (p. 16-19).
Uncertainties:
- The precise impact of new standards on economic financing and growth remains to be monitored, justifying observation periods and review clauses (p. 18).
- The effectiveness of countercyclical buffers will depend on their activation and calibration by national authorities, which may vary by jurisdiction (p. 15).
- Full implementation of standards requires sustained international cooperation and adaptation of banking practices.
The Basel Committee concludes that the financial crisis demonstrated the need for a strengthened, more coherent, and more resilient banking regulatory framework, integrating increased capital requirements, better liquidity risk management, and macroprudential measures to limit procyclicality and systemic risk (p. 9-19).
The main recommendations are:
- Adopt a strict and harmonized definition of capital, with strong weighting of Common Equity Tier 1 and rigorous eligibility criteria for other capital instruments (p. 20-26).
- Introduce a leverage ratio as a complementary measure to control overall indebtedness (p. 12-13).
- Establish capital buffers, notably a conservation buffer and a countercyclical buffer, to strengthen loss absorption capacity during stress periods (p. 13-16).
- Implement international liquidity standards (LCR and NSFR) to ensure short- and long-term resilience (p. 16-19).
- Provide transitional periods for progressive implementation and limit negative effects on credit to the economy (p. 18).
- Enhance transparency and disclosure of capital and risk information to improve market discipline (p. 10).
The Committee emphasizes the importance of ongoing international cooperation to ensure consistent and effective application of Basel III standards, as well as the need to monitor economic impacts and adjust rules accordingly.
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