The Basel Committee on banking supervision started working on an international framework to enhance banking regulatory reforms and mitigate the risks. The Basel Committee started out working immediately after the notorious global financial crunch in 2008.
The current frame of proposed reforms for the banking industry is called the Basel III (03) or third Basel accord. It aims to formulate a rigorous regulatory framework internationally agreed upon to mitigate the liquidity and credit default risks of banks.
The Basel III accord aims to enhance banking industry security and creditworthiness mainly addressing the liquidity and capital requirements.
Basel III is an agreed-upon accord by 28 international countries’ central banks. The current date of implementation of agreed-upon changes is set to January 2022. Its international participation aims to regulate international banks under a common framework and regulatory standards.
Banks keep two types of capital, classified into Tier 1 and Tier 02 capital. The Basel III accord aims to assess the total capital of the banks by adding Tier 01 and Tier 02 capital and dividing it by weighted assets.
By definition, the Tier 01 capital of the banks includes common shares, retained earnings, and reserves in the equity section. All capital debt instruments with no fixed maturity dates. Tier 02 capital includes subordinated loans held by the banks.
The Basel III accord issued a new set of regulatory and compliance framework mainly addressing the capital structure of the banks and leverage.
Capital Adequacy and Quality Requirements:
The Basel III accord requires banks to maintain a combined Tier 01 and Tier 02 capital ratio that must not be less than 8%. The capital ratio should be calculated by adding both Tier 01 and Tier 02 capitals and divided by risk-weighted assets.
For common stocks, the minimum capital requirement has been raised to 4.5% of the risk-weighted assets. It further regulates the capital to be written off or converted to common stock in case of the bank is judged to be non-viable.
The banks are also grouped according to the size and complexity in structure. Banks with expansion plans are required to set aside additional capital or raise the capital requirement ratio.
Minimum Leverage Ratio Requirements:
The Basel III accord aimed to build on a framework with a risk-weighted assets approach. It requires banks to maintain an adequate on-balance and off-balance sheet leverage. Its new regulatory implementation requires banks to maintain high-quality liquid assets to maintain a financially stressed situation for up to 30 days.
The accord also proposed a long-term net stable funding ratio framework to remove any short-term liquidity mismatches in the balance sheet. The Basel III accord proposed a continuous monitoring and supervision network to assess and decide the financial stress scenarios. The monitoring framework also includes the scope of long-term liquidity and leverage trends supervision.
Basel III Risk Coverage Framework:
The Basel III accord proposed to widen the risk assessment coverage of the banks. The immediate corrective measure it announced was the restriction of banks’ internal control models.
The internal control models adapted differently by different banks would mean different risk-weighted assets and uneven risk assessments for both capital and leverage risks. The Basel III accord proposed a standardized approach in assessing banking industry risks with:
- Market risk
- Credit Risk
- Operational risk assessment
- Credit valuation adjustments – the risk-weighted assets approach
The accord aims to propose a risk assessment model for banks both internal measures and industry-wide external risks. It stresses internal governance model improvements pointing to adequate risk assessment measures on off-balance sheet assets and securities held by the banks.
The Basel III accord was initiated to introduce strict regulatory measures in the banking industry. The negotiated accord now requires banks to maintain more capital and better leverage ratios. It also restricts the internal assessment modules implemented by banks differently.
Stricter regulations can mean the industry moves towards a safer and less risk-prone financial market in the future. However, it also means the operating costs for banks increase.
A higher Equity rate and lower debt ratio would mean a higher total cost of capital for banks. Maintaining a higher capital ratio and mitigating leverage risks would mean less profitability for banks.
The success of the Basel III accord would depend on the proposed implementations by the banks. However, safer financial markets would increase investors’ trust in banking products such as securities and bonds. A higher level of capital ratio and better liquidity ratios would mean safer investments in capital instruments like bonds.
That in turn can also act as a balancing act for banks’ loss of profitability in the long-term. The investors will be keener to invest in safe investments offered by highly regulated banks.