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  • Basel III is a global, voluntary regulatory standard on bank capital adequacy, stress

  • testing and market liquidity risk. It was agreed upon by the members of the Basel Committee

  • on Banking Supervision in 2010–11, and was scheduled to be introduced from 2013 until

  • 2015; however, changes from 1 April 2013 extended implementation until 31 March 2018 and again

  • extended to 31 March 2019. The third installment of the Basel Accords was developed in response

  • to the deficiencies in financial regulation revealed by the late-2000s financial crisis.

  • Basel III was supposed to strengthen bank capital requirements by increasing bank liquidity

  • and decreasing bank leverage.

  • General Overview Unlike Basel I and Basel II which are primarily

  • related to the required level of bank loss reserves that must be held by banks for various

  • classes of loans and other investments and assets that they have, Basel III is primarily

  • related to the risks for the banks of a run on the bank by requiring differing levels

  • of reserves for different forms of bank deposits and other borrowings. Therefore contrary to

  • what might be expected by the name, Basel III rules do not for the most part supersede

  • the guidelines known as Basel I and Basel II but work alongside them.

  • Key principles Capital requirements

  • The original Basel III rule from 2010 was supposed to require banks to hold 4.5% of

  • common equity and 6% of Tier I capital of "risk-weighted assets". Basel III introduced

  • "additional capital buffers", a "mandatory capital conservation buffer" of 2.5% and a

  • "discretionary counter-cyclical buffer", which would allow national regulators to require

  • up to another 2.5% of capital during periods of high credit growth.

  • Leverage ratio Basel III introduced a minimum "leverage ratio".

  • The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total

  • consolidated assets; The banks were expected to maintain a leverage ratio in excess of

  • 3% under Basel III. In July 2013, the US Federal Reserve Bank announced that the minimum Basel

  • III leverage ratio would be 6% for 8 Systemically important financial institution banks and

  • 5% for their insured bank holding companies. Liquidity requirements

  • Basel III introduced two required liquidity ratios. The "Liquidity Coverage Ratio" was

  • supposed to require a bank to hold sufficient high-quality liquid assets to cover its total

  • net cash outflows over 30 days; the Net Stable Funding Ratio was to require the available

  • amount of stable funding to exceed the required amount of stable funding over a one-year period

  • of extended stress. US Version of the Basel Liquidity Coverage

  • Ratio Requirements On 24 October 2013, the Federal Reserve Board

  • of Governors approved an interagency proposal for the U.S. version of the Basel Committee

  • on Banking Supervision's Liquidity Coverage Ratio. The ratio would apply to certain U.S.

  • banking organizations and other systematically important financial institutions. The comment

  • period for the proposal is scheduled to close by 31 January 2014.

  • The U.S. LCR proposal came out significantly tougher than BCBS’s version, especially

  • for larger bank holding companies. The proposal requires financial institutions and FSOC designated

  • nonbank financial companies to have an adequate stock of High Quality Liquid Assets that can

  • be quickly liquidated to meet liquidity needs over a short period of time.

  • 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.

  • The Liquidity Coverage Ratio applies to US banking operations with assets of more than

  • 10 billion. The proposal would require: Large Bank Holding Companiesthose with

  • over $250 billion in consolidated assets, or more in on-balance sheet foreign exposure,

  • and to systemically important, non-bank financial institutions; to hold enough HQLA to cover

  • 30 days of net cash outflow. That amount would be determined based on the peak cumulative

  • amount within the 30 day period. Regional firms would be subject to a “modified

  • LCR at the level only. The modified LCR requires the regional firms to hold enough HQLA to

  • cover 21 days of net cash outflow. The net cash outflow parameters are 70% of those applicable

  • to the larger institutions and do not include the requirement to calculate the peak cumulative

  • outflows Smaller BHCs, those under $50 billion, would

  • remain subject to the prevailing qualitative supervisory framework.

  • The US proposal divides qualifying High Quality Liquid Assets into three specific categories.

  • Across the categories the combination of Level 2A and 2B assets cannot exceed 40% HQLA with

  • 2B assets limited to a maximum of 15% of HQLA. Level 1 represents assets that are highly

  • liquid and receive no haircut. Notably, the Fed chose not to include GSE-issued securities

  • in Level 1, despite industry lobbying, on the basis that they are not guaranteed by

  • the full faith and credit of the US government. Level 2A assets generally include assets that

  • would be subject to a 20% risk-weighting under Basel III and includes assets such as GSE-issued

  • and -guaranteed securities. These assets would be subject to a 15% haircut which is similar

  • to the treatment of such securities under the BCBS version.

  • Level 2B assets include corporate debt and equity securities and are subject to a 50%

  • haircut. The BCBS and US version treats equities in a similar manner, but corporate debt under

  • the BCBS version is split between 2A and 2B based on public credit ratings, unlike the

  • US proposal. This treatment of corporate debt securities is the direct impact of DFA’s

  • Section 939 and further evidences the conservative bias of US regulatorsapproach to the LCR.

  • The proposal requires that the LCR be at least equal to or greater than 1.0 and includes

  • a multiyear transition period that would require: 80% compliance starting 1 January 2015, 90%

  • compliance starting 1 January 2016, and 100% compliance starting 1 January 2017.

  • Lastly, the proposal requires both sets of firms subject to the LCR requirements to submit

  • remediation plans to U.S. regulators to address what actions would be taken if the LCR falls

  • below 100% for three consecutive days or longer. Implementation

  • Summary of originally proposed changes in Basel Committee language

  • First, the quality, consistency, and transparency of the capital base will be raised.

  • Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained

  • earnings Tier 2 capital: supplementary capital, however,

  • the instruments will be harmonised Tier 3 capital will be eliminated.

  • Second, the risk coverage of the capital framework will be strengthened.

  • Promote more integrated management of market and counterparty credit risk

  • Add the CVA-risk due to deterioration in counterparty's credit rating

  • Strengthen the capital requirements for counterparty credit exposures arising from banks' derivatives,

  • repo and securities financing transactions Raise the capital buffers backing these exposures

  • Reduce procyclicality and Provide additional incentives to move OTC

  • derivative contracts to qualifying central counterparties. Currently, the BCBS has stated

  • derivatives cleared with a QCCP will be risk-weighted at 2%

  • Provide incentives to strengthen the risk management of counterparty credit exposures

  • Raise counterparty credit risk management standards by including wrong-way risk

  • Third, a leverage ratio will be introduced as a supplementary measure to the Basel II

  • risk-based framework, intended to achieve the following objectives:

  • Put a floor under the build-up of leverage in the banking sector

  • Introduce additional safeguards against model risk and measurement error by supplementing

  • the risk based measure with a simpler measure that is based on gross exposures.

  • Fourth, a series of measures is introduced to promote the build up of capital buffers

  • in good times that can be drawn upon in periods of stress.

  • Measures to address procyclicality: Dampen excess cyclicality of the minimum capital

  • requirement; Promote more forward looking provisions;

  • Conserve capital to build buffers at individual banks and the banking sector that can be used

  • in stress; and

  • Achieve the broader macroprudential goal of protecting the banking sector from periods

  • of excess credit growth. Requirement to use long term data horizons

  • to estimate probabilities of default, downturn loss-given-default estimates, recommended

  • in Basel II, to become mandatory Improved calibration of the risk functions,

  • which convert loss estimates into regulatory capital requirements.

  • Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.

  • Promoting stronger provisioning practices: Advocating a change in the accounting standards

  • towards an expected loss approach.

  • Fifth,a global minimum liquidity standard for internationally active banks is introduced

  • that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term

  • structural liquidity ratio called the Net Stable Funding Ratio.

  • The Committee also is reviewing the need for additional capital, liquidity or other supervisory

  • measures to reduce the externalities created by systemically important institutions.

  • As of September 2010, proposed Basel III norms asked for ratios as: 7–9.5% + 0–2.5%)

  • for common equity and 8.5–11% for Tier 1 capital and 10.5–13% for total capital.

  • On 15 April, the Basel Committee on Banking Supervision released the final version of

  • itsSupervisory Framework for Measuring and Controlling Large Exposuresthat builds

  • upon longstanding BCBS guidance on credit exposure concentrations.

  • U.S. implementation The U.S. Federal Reserve announced in December

  • 2011 that it would implement substantially all of the Basel III rules. It summarized

  • them as follows, and made clear they would apply not only to banks but also to all institutions

  • with more than US$50 billion in assets: "Risk-based capital and leverage requirements"

  • including first annual capital plans, conduct stress tests, and capital adequacy "including

  • a tier one common risk-based capital ratio greater than 5 percent, under both expected

  • and stressed conditions" – see scenario analysis on this. A risk-based capital surcharge

  • Market liquidity, first based on the US's own "interagency liquidity risk-management

  • guidance issued in March 2010" that require liquidity stress tests and set internal quantitative

  • limits, later moving to a full Basel III regime - see below.

  • The Federal Reserve Board itself would conduct tests annually "using three economic and financial

  • market scenarios." Institutions would be encouraged to use at least five scenarios reflecting

  • improbable events, and especially those considered impossible by management, but no standards

  • apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including

  • company-specific information, would be made public" but one or more internal company-run

  • stress tests must be run each year with summaries published.

  • Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a

  • single counterparty as a percentage of the firm's regulatory capital. Credit exposure

  • between the largest financial companies would be subject to a tighter limit."

  • "Early remediation requirements" to ensure that "financial weaknesses are addressed at

  • an early stage". One or more "triggers for remediationsuch as capital levels, stress

  • test results, and risk-management weaknessesin some cases calibrated to be forward-looking"

  • would be proposed by the Board in 2012. "Required actions would vary based on the severity of

  • the situation, but could include restrictions on growth, capital distributions, and executive

  • compensation, as well as capital raising or asset sales."

  • As of January 2014, the U.S. has been on track to implement many of the Basel III rules,

  • however differences remain in ratio requirements and calculations.

  • Key milestones Capital requirements

  • Leverage ratio Liquidity requirements

  • Analysis on Basel III impact Macroeconomic impact

  • An OECD study released on 17 February 2011, estimated that the medium-term impact of Basel

  • III implementation on GDP growth would be in the range of −0.05% to −0.15% per year.

  • Economic output would be mainly affected by an increase in bank lending spreads, as banks

  • pass a rise in bank funding costs, due to higher capital requirements, to their customers.

  • To meet the capital requirements originally effective in 2015 banks were estimated to

  • increase their lending spreads on average by about 15 basis points. Capital requirements

  • effective as of 2019 could increase bank lending spreads by about 50 basis points. The estimated

  • effects on GDP growth assume no active response from monetary policy. To the extent that monetary

  • policy would no longer be constrained by the zero lower bound, the Basel III impact on

  • economic output could be offset by a reduction in monetary policy rates by about 30 to 80

  • basis points. Critics

  • Think-tanks such as the World Pensions Council have argued that Basel III merely builds on

  • and further expands the existing Basel II regulatory base, without questioning fundamentally

  • its core tenets, notably the ever-growing reliance on standardized assessments of "credit