Basel iii Accord

The Basel iii Accord

The Basel III Accord is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision ("Basel Committee").

The Basel Committee is the primary global standard-setter for the prudential regulation of banks, and provides a forum for cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

The Basel Committee is a Committee of the Bank for International Settlements (BIS), an international organisation which fosters international monetary and financial cooperation and serves as a bank for central banks. Established in 1930, the BIS is owned by 63 central banks, representing countries from around the world that together account for about 95% of world GDP.

The Basel Committee reports to the Group of Governors and Heads of Supervision (GHOS), and seeks the endorsement of GHOS for its major decisions and its work programme.

The Basel Committee's members come from Argentina, Australia, Belgium, Brazil, Canada, China, European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States.

From 1993 to 2008 the total assets of a sample of what we call global systemically important banks saw a twelve-fold increase (increasing from $2.6 trillion to just over $30 trillion). But the capital funding these assets only increased seven-fold, (from $125 billion to $890 billion). Put differently, the average risk weight declined from 70% to below 40%.

The problem was that this reduction did not represent a genuine reduction in risk in the banking system. One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on and off-balance sheet leverage.

This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system.

The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions. During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions.

The weaknesses in the banking sector were rapidly transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability.

Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing taxpayers to large losses. The effect on banks, financial systems, and economies at the epicenter of the crisis was immediate.

However, the crisis also spread to a wider circle of countries around the globe. For these countries, the transmission channels were less direct, resulting from a severe contraction in global liquidity, cross-border credit availability and demand for exports.

Given the scope and speed with which the recent and previous crises have been transmitted around the globe as well as the unpredictable nature of future crises, it is critical that all countries raise the resilience of their banking sectors to both internal and external shocks.

The G20 Leaders at the Seoul Summit endorsed the Basel III framework and the Financial Stability Board’s (FSB) policy framework for reducing the moral hazard of systemically important financial institutions (SIFIs), including the work processes and timelines set out in the report submitted to the Summit.

SIFIs are financial institutions whose disorderly failure, because of their size, complexity, and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity.

We read in the final G20 Communique:

"We endorsed the landmark agreement reached by the Basel Committee on the new bank capital and liquidity framework, which increases the resilience of the global banking system by raising the quality, quantity and international consistency of bank capital and liquidity, constrains the build-up of leverage and maturity mismatches, and introduces capital buffers above the minimum requirements that can be drawn upon in bad times.

The framework includes an internationally harmonized leverage ratio to serve as a backstop to the risk-based capital measures. With this, we have achieved far-reaching reform of the global banking system.

The new standards will markedly reduce banks' incentive to take excessive risks, lower the likelihood and severity of future crises, and enable banks to withstand - without extraordinary government support - stresses of a magnitude associated with the recent financial crisis.

This will result in a banking system that can better support stable economic growth. We are committed to adopt and implement fully these standards within the agreed timeframe that is consistent with economic recovery and financial stability.

The new framework will be translated into our national laws and regulations, and will be implemented starting on January 1, 2013 and fully phased in by January 1, 2019."

To ensure visibility of the implementation of reforms, the Basel Committee has been regularly publishing information about members’ adoption of Basel III to keep all stakeholders and the markets informed, and to maintain peer pressure where necessary.

It is especially important that jurisdictions that are home to global systemically important banks (G-SIBs) make every effort to issue final regulations at the earliest possible opportunity. But simply issuing domestic rules is not enough to achieve what the G20 Leaders asked for: full, timely and consistent implementation of Basel III.

In response to this call, in 2012 the Committee initiated what has become known as the Regulatory Consistency Assessment Programme (RCAP). The regular progress reports are simply one part of this programme, which assesses domestic regulations’ compliance with the Basel standards, and examines the outcomes at individual banks. The RCAP process will be fundamental to ensuring confidence in regulatory ratios and promoting a level playing field for internationally-operating banks.

It is inevitable that, as the Committee begins to review aspects of the regulatory framework in far more detail than it (or anyone else) has ever done in the past, there will be aspects of implementation that do not meet the G20’s aspiration: full, timely and consistent.

The financial crisis identified that, like the standards themselves, implementation of global standards was not as robust as it should have been. This could be classed as a failure by global standard setters.

To some extent, the criticism can be justified – not enough has been done in the past to ensure global agreements have been truly implemented by national authorities. However, just as the Committee has been determined to revise the Basel framework to fix the problems that emerged from the lessons of the crisis, the RCAP should be seen as demonstrating the Committee’s determination to also find implementation problems and fix them.

December 2017 - Finalization of the Basel III post-crisis regulatory reforms

The Basel III reforms complement the initial phase of the Basel III reforms announced in 2010.

The 2017 reforms seek to restore credibility in the calculation of risk weighted assets (RWAs) and improve the comparability of banks’ capital ratios.

RWAs are an estimate of risk that determines the minimum level of regulatory capital a bank must maintain to deal with unexpected losses.

A prudent and credible calculation of RWAs is an integral element of the risk-based capital framework.

The revisions seek to restore credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks’ capital ratios by:

• enhancing the robustness and risk sensitivity of the standardised approaches for credit risk, credit valuation adjustment (CVA) risk and operational risk;

• constraining the use of the internal model approaches, by placing limits on certain inputs used to calculate capital requirements under the internal ratings-based (IRB) approach for credit risk and by removing the use of the internal model approaches for CVA risk and for operational risk;

• introducing a leverage ratio buffer to further limit the leverage of global systemically important banks (G-SIBs); and

• replacing the existing Basel II output floor with a more robust risk-sensitive floor based on the Committee’s revised Basel III standardised approaches.

Credit risk

Credit risk accounts for the bulk of most banks’ risk-taking activities and hence their regulatory capital requirements. The standardised approach is used by the majority of banks around the world, including in non-Basel Committee jurisdictions. The Committee’s revisions to the standardised approach for credit risk enhance the regulatory framework by:

• improving its granularity and risk sensitivity. For example, the Basel II standardised approach assigns a flat risk weight to all residential mortgages. In the revised standardised approach mortgage risk weights depend on the loan-to-value (LTV) ratio of the mortgage;

• reducing mechanistic reliance on credit ratings, by requiring banks to conduct sufficient due diligence, and by developing a sufficiently granular non-ratings-based approach for jurisdictions that cannot or do not wish to rely on external credit ratings; and

• as a result, providing the foundation for a revised output floor to internally modelled capital requirements (to replace the existing Basel I floor) and related disclosure to enhance comparability across banks and restore a level playing field.

In summary, the key revisions are as follows:

• A more granular approach has been developed for unrated exposures to banks and corporates, and for rated exposures in jurisdictions where the use of credit ratings is permitted.

• For exposures to banks, some of the risk weights for rated exposures have been recalibrated. In addition, the risk-weighted treatment for unrated exposures is more granular than the existing flat risk weight. A standalone treatment for covered bonds has also been introduced.

• For exposures to corporates, a more granular look-up table has been developed. A specific risk weight applies to exposures to small and medium-sized enterprises (SMEs). In addition, the revised standardised approach includes a standalone treatment for exposures to project finance, object finance and commodities finance.

• For residential real estate exposures, more risk-sensitive approaches have been developed, whereby risk weights vary based on the LTV ratio of the mortgage (instead of the existing single risk weight) and in ways that better reflect differences in market structures.

• For retail exposures, a more granular treatment applies, which distinguishes between different types of retail exposures. For example, the regulatory retail portfolio distinguishes between revolving facilities (where credit is typically drawn upon) and transactors (where the facility is used to facilitate transactions rather than a source of credit).

• For commercial real estate exposures, approaches have been developed that are more risk sensitive than the flat risk weight which generally applies.

• For subordinated debt and equity exposures, a more granular risk weight treatment applies (relative to the current flat risk weight).

• For off-balance sheet items, the credit conversion factors (CCFs), which are used to determine the amount of an exposure to be risk-weighted, have been made more risk-sensitive, including the introduction of positive CCFs for unconditionally cancellable commitments (UCCs).

The CVA framework

The initial phase of Basel III reforms introduced a capital charge for potential mark-to-market losses of derivative instruments as a result of the deterioration in the creditworthiness of a counterparty.

This risk – known as CVA risk – was a major source of losses for banks during the global financial crisis, exceeding losses arising from outright defaults in some instances. The Committee has agreed to revise the CVA framework to:

• enhance its risk sensitivity: the current CVA framework does not cover an important driver of CVA risk, namely the exposure component of CVA. This component is directly related to the price of the transactions that are within the scope of application of the CVA risk capital charge.

As these prices are sensitive to variability in underlying market risk factors, the CVA also materially depends on those factors. The revised CVA framework takes into account the exposure component of CVA risk along with its associated hedges;

• strengthen its robustness: CVA is a complex risk, and is often more complex than the majority of the positions in banks’ trading books. Accordingly, the Committee is of the view that such a risk cannot be modelled by banks in a robust and prudent manner.

The revised framework removes the use of an internally modelled approach, and consists of:

(i) a standardised approach; and

(ii) a basic approach. In addition, a bank with an aggregate notional amount of non-centrally cleared derivatives less than or equal to €100 billion may calculate their CVA capital charge as a simple multiplier of its counterparty credit risk charge.

• improve its consistency: CVA risk is a form of market risk as it is realised through a change in the mark-to-market value of a bank’s exposures to its derivative counterparties.

As such, the standardised and basic approaches of the revised CVA framework have been designed and calibrated to be consistent with the approaches used in the revised market risk framework. In particular, the standardised CVA approach, like the market risk approaches, is based on fair value sensitivities to market risk factors and the basic approach is benchmarked to the standardised approach.

Operational risk

The financial crisis highlighted two main shortcomings with the existing operational risk framework.

First, capital requirements for operational risk proved insufficient to cover operational risk losses incurred by some banks.

Second, the nature of these losses – covering events such as misconduct, and inadequate systems and controls – highlighted the difficulty associated with using internal models to estimate capital requirements for operational risk.

The Committee has streamlined the operational risk framework. The advanced measurement approaches (AMA) for calculating operational risk capital requirements (which are based on banks’ internal models) and the existing three standardised approaches are replaced with a single risk-sensitive standardised approach to be used by all banks.

The new standardised approach for operational risk determines a bank’s operational risk capital requirements based on two components:

(i) a measure of a bank’s income; and

(ii) a measure of a bank’s historical losses.

Conceptually, it assumes:

(i) that operational risk increases at an increasing rate with a bank’s income; and

(ii) banks which have experienced greater operational risk losses historically are assumed to be more likely to experience operational risk losses in the future.

The leverage ratio complements the risk-weighted capital requirements by providing a safeguard against unsustainable levels of leverage and by mitigating gaming and model risk across both internal models and standardised risk measurement approaches.

The leverage ratio

To maintain the relative incentives provided by both capital constraints, the finalised Basel III reforms introduce a leverage ratio buffer for G-SIBs. Such an approach is consistent with the risk-weighted G-SIB buffer, which seeks to mitigate the externalities created by G-SIBs.

The leverage ratio G-SIB buffer must be met with Tier 1 capital and is set at 50% of a G-SIB’s risk weighted higher-loss absorbency requirements. For example, a G-SIB subject to a 2% risk-weighted higher-loss absorbency requirement would be subject to a 1% leverage ratio buffer requirement.

The leverage ratio buffer takes the form of a capital buffer akin to the capital buffers in the risk weighted framework. As such, the leverage ratio buffer will be divided into five ranges.

As is the case with the risk-weighted framework, capital distribution constraints will be imposed on a G-SIB that does not meet its leverage ratio buffer requirement. The distribution constraints imposed on a G-SIB will depend on its CET1 risk-weighted ratio and Tier 1 leverage ratio.

A G-SIB that meets:

(i) its CET1 risk-weighted requirements (defined as a 4.5% minimum requirement, a 2.5% capital conservation buffer and the G-SIB higher loss-absorbency requirement) and;

(ii) its Tier 1 leverage ratio requirement (defined as a 3% leverage ratio minimum requirement and the G-SIB leverage ratio buffer) will not be subject to distribution constraints.

A G-SIB that does not meet one of these requirements will be subject to the associated minimum capital conservation requirement (expressed as a percentage of earnings). A G-SIB that does not meet both requirements will be subject to the higher of the two associated conservation requirements.

What is next?

The finalisation of Basel III in December 2017 represents an important milestone for the Basel Committee’s response to the global financial crisis. The full set of Basel III reforms will help enhance the resilience of the banking system.

The Basel Committee will continue to exercise its mandate to strengthen the regulation, supervision, and practices of banks worldwide. The agenda changes, but the purpose is constant – to safeguard and enhance financial stability.

The Basel Committee has agreed that jurisdictions may exercise national discretion in periods of exceptional macroeconomic circumstances to exempt central bank reserves from the leverage ratio exposure measure on a temporary basis.

Jurisdictions that exercise this discretion would be required to recalibrate the minimum leverage ratio requirement commensurately to offset the impact of excluding central bank reserves, and require their banks to disclose the impact of this exemption on their leverage ratios.

The Committee continues to monitor the impact of the Basel III leverage ratio’s treatment of client-cleared derivative transactions. It will review the impact of the leverage ratio on banks’ provision of clearing services and any consequent impact on the resilience of central counterparty clearing.

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Scope and definitions.

This framework will be applied on a consolidated basis to internationally active banks. Consolidated supervision is the best means to provide supervisors with a comprehensive view of risks and to reduce opportunities for regulatory arbitrage.

The scope of application of the framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group.

Banking groups are groups that engage predominantly in banking activities and, in some countries, a banking group may be registered as a bank.

A holding company that is a parent of a banking group may itself have a parent holding company. In some structures, this parent holding company may not be subject to this framework because it is not considered a parent of a banking group.

The framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis.

As an alternative to full sub-consolidation, the application of this framework to the stand-alone bank (ie on a basis that does not consolidate assets and liabilities of subsidiaries) would achieve the same objective, providing the full book value of any investments in subsidiaries and significant minority-owned stakes is deducted from the bank’s capital.

Further, to supplement consolidated supervision, it is essential to ensure that capital recognised in capital adequacy measures is adequately distributed amongst legal entities of a banking group. Accordingly, supervisors should test that individual banks are adequately capitalised on a stand-alone basis.

Banking, securities and other financial subsidiaries.

To the greatest extent possible, all banking and other relevant financial activities (both regulated and unregulated) conducted within a group containing an internationally active bank will be captured through consolidation. Thus, majority -owned or -controlled banking entities, securities entities (where subject to broadly similar regulation or where securities activities are deemed banking activities) and other financial entities should generally be fully consolidated.

“Financial activities” do not include insurance activities and “financial entities” do not include insurance entities.

Examples of the types of activities that financial entities might be involved in include financial leasing, issuing credit cards, portfolio management, investment advisory, custodial and safekeeping services and other similar activities that are ancillary to the business of banking.

There may be instances where it is not feasible or desirable to consolidate certain securities or other regulated financial entities. This would be only in cases where such holdings are acquired through debt previously contracted and held on a temporary basis, are subject to different regulation, or where non-consolidation for regulatory capital purposes is otherwise required by law. In such cases, it is imperative for the bank supervisor to obtain sufficient information from supervisors responsible for such entities.

If any majority-owned securities and other financial subsidiaries are not consolidated for capital purposes, all equity and other regulatory capital (or, if applicable, other total loss-absorbing capacity) investments in those entities attributable to the group will be deducted, and the assets and liabilities, as well as third-party capital investments in the subsidiary will be removed from the bank’s balance sheet.

Supervisors will ensure that an entity that is not consolidated and for which the capital investment is deducted meets regulatory capital requirements. Supervisors will monitor actions taken by the subsidiary to correct any capital shortfall and, if it is not corrected in a timely manner, the shortfall will also be deducted from the parent bank’s capital.

Significant minority investments in banking, securities and other financial entities, where control does not exist, will be excluded from the banking group’s capital by deduction of the equity and other regulatory investments. Alternatively, such investments might be, under certain conditions, consolidated on a pro rata basis.

For example, pro rata consolidation may be appropriate for joint ventures or where the supervisor is satisfied that the parent is legally or de facto expected to support the entity on a proportionate basis only and the other significant shareholders have the means and the willingness to proportionately support it. The threshold above which minority investments will be deemed significant and be thus either deducted or consolidated on a pro-rata basis is to be determined by national accounting and/or regulatory practices. As an example, the threshold for pro-rata inclusion in the European Union is defined as equity interests of between 20% and 50%.

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