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 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 the third Basel accord.
It aims to formulate a rigorous regulatory framework internationally agreed upon to mitigate banks’ liquidity and credit default risks.
The Basel III accord aims to enhance banking industry security and creditworthiness, mainly addressing 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 banks’ total capital 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 new regulatory and compliance frameworks 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 dividing 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 their size and complexity in the structure. Banks with expansion plans must 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 supervision of long-term liquidity and leverage trends.
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 to assessing banking industry risks with the following:
- Market risk
- Credit Risk
- Operational risk assessment
- Credit valuation adjustments – the risk-weighted assets approach
The accord proposes a risk assessment model for banks’ 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 introduced 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 bank profitability.
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 capital ratio and better liquidity ratios would mean safer investments in capital instruments like bonds.
That can also act as a balancing act for banks’ long-term profitability loss. The investors will be keener to invest in safe investments offered by highly regulated banks.
Main Objective of Basel 3
The primary objective of Basel III is to promote a more resilient banking system by raising capital and liquidity standards for global banks.
The new regulations aim to ensure that banks have enough capital to absorb losses in times of financial crises while also ensuring they maintain a sufficient liquidity level that allows them to repay their obligations when due quickly.
Basel III also introduces a countercyclical buffer requirement requiring banks to hold additional capital during periods of high credit growth to reduce the risk of a rapid contraction in the event of an economic downturn.
Additionally, the regulations introduce stricter leverage and leverage ratio requirements and stricter criteria regarding limitations on the amount of certain types of assets that a bank can hold.
Why Basel 3 is Important for the Banking Industry
Basel III is an essential set of regulations introduced to strengthen the banking system in response to the financial crisis of 2008.
The reforms aim to create a more resilient banking industry by increasing capital and liquidity requirements, curbing excessive risk-taking, and promoting greater transparency in the banking sector.
By introducing new capital standards and leverage ratio requirements, banks are incentivized to diversify their investments, increase their countercyclical reserve buffer during periods of high credit growth, and adhere to specific risk management practices.
These measures are designed to ensure that banks are better able to withstand future market shocks without experiencing losses on an unprecedented scale, as occurred during the financial crisis of 2008.
This helps limit systemic risk, reduce market volatility, and ensure that banks remain stable and reliable sources of funding for businesses and households.
The implementation of Basel III also sets a global standard for supervision, allowing countries worldwide to coordinate better when responding to potential risks from major financial institutions.
This helps create trust within global markets, encourages investment, and promotes economic stability.
What is the Limitation of Basel 3?
Basel III has been criticized for not being stringent enough in its regulations. For example, the leverage ratio requirement has been criticized for being too low as it does not put sufficient pressure on banks to reduce their reliance on borrowing and maintain sufficient capital reserves for times of crisis.
Additionally, the countercyclical buffer requirements may be too weak to curb lending effectively during periods of high credit growth and protect against future financial shocks.
The cost of complying with the new regulations is also a concern, as it requires banks to devote resources towards meeting the higher standards which could otherwise be used more productively elsewhere.
This could lead to reduced profitability for smaller banks struggling to comply with the new regulations due to a lack of resources or understanding of the new rules.
Additionally, some argue that Basel III disproportionately affects smaller lenders who do not have access to global markets and, therefore, cannot diversify as effectively as larger firms.
