Basel III Regulatory Framework for Financial Institutions

It is important for CFA® charterholders and candidates to understand the foundations of global banking regulation, currently within the framework of Basel III. This third iteration of the framework has built upon Basel I and II by mandating reinforced and stronger capital ratios and higher-quality capital, and supplementing capital requirements with leverage ratio and minimum liquidity requirements. Looking towards the further iteration of Basel IV, it is hoped that the third framework provides a solid structure for increasingly globalized banking systems.

It is a fundamental principle that banks should maintain sufficient equity capital to avoid solvency problems. The riskier a bank’s assets, the more capital it needs. Capital gives a bank the ability to absorb losses while it remains a going concern:

  • It should be perpetual—that is, as long as the bank remains in business, it should not be obliged to repay the original investment to capital investors.

  • Distributions to investors (e.g., in the form of dividends) are not obligatory and usually vary over time.

  • The flip side of these characteristics is that shareholders can generally expect to receive a higher return in the long run relative to debt investors.

The Basel Regulations on Bank Capital Management

The Basel I regulations, published in 1988, established global risk-based minimum capital standards for banks (to ensure that banks from different countries competing for the same loans would have to hold roughly the same amount of capital to support them). The focus was on credit risk.

Under the rules, banks were required to hold capital equating to at least 8% of their risk-weighted assets (this was known as the Cooke ratio after Peter Cooke, the chairman of the Basel Committee at the time). Assets were allocated a risk weight, ranging between 0% and 100% according to their perceived riskiness from a credit perspective. The idea of the rules was to prevent international banks from growing business volumes too quickly without adequate capital backing.

Basel I Example Capital and Risk Weights

 Key changes to Basel regulations post-1988 included:

Market risk amendment (1996, requiring capital for market risk), Basel II capital framework (2004), Basel 2.5 market risk capital amendment (2009), Basel III framework (2010) and Basel III finalization (2015 onward). 

Basel II was a revised framework incorporating three pillars around minimum capital requirements, bank internal assessment of risks, and effective use of disclosure to strengthen market discipline. It introduced a new menu of approaches to risk measurement and included explicit capital requirements for operational risk.

 Basel III

The major changes under Basel III include:

  • New classes of capital:

    • Common  Equity Tier 1 (CET1)—ordinary shareholders funds and reserves, subject to tight qualifying criteria

    • Additional Tier 1—hybrid equity instruments satisfying tight qualifying criteria.

      • Most Basel II Tier 1 instruments fail to comply due to factors like step-ups, stated maturities, and requirement to be convertible to CET1.

    • Tier 1 equals Common Equity Tier 1 plus Additional Tier 1

  •  Upper and Lower Tier 2 collapsed into a single Tier 2 category

  •  Tier 3 capital abolished

  •  Tighter minimum ratios going forward

    • Minimum Common Equity Tier 1 ratio of 4.5%

    • Minimum Tier 1 capital increased from 4% to 6%

    • Minimum Tier 2 capital reduced to 2%

  • The capital conservation buffer of 2.5% of risk-weighted assets applies at all times and has to be met with capital of the highest quality (Common Equity Tier 1).

  • The purpose of the countercyclical capital buffer is to protect the banking sector and the real economy from the system-wide risks stemming from the boom-bust evolution in aggregate credit growth.

  • Implementation commenced in 2016 and this buffer will ultimately be established at up to 2.5% of risk-weighted assets.

Systemic Risk Buffers

Three new buffers are being implemented:

  • Systemic risk buffer—not set on an individual firm basis, but applied to the whole financial sector or subsets of it (no maximum)

  • Global Systemically Important Institution (G-SII) Buffer—set on an individual basis. GSIIs allocated to one of five sub-categories depending upon systemic importance (maximum 3.5%, though highest applied is 2.5%)

  • Other Systemically Important Institution (O-SII) Buffer – set on an individual basis and capped at 2%

Liquidity Requirements: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)

The LCR is calculated as:

Stock of high quality liquid assets ÷ Total net cash outflows over the next 30 calendar days ≥ 100%.

It is designed to ensure that a financial institution has sufficient unencumbered, high-quality liquid resources  to survive a severe liquidity stress scenario lasting for one month.

The NSFR is calculated as:

Available amount of stable funding ÷ Required amount of stable funding ≥ 100%.

The objective is to promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis. It places a formal limit on the amount of maturity transformation that banks are able to undertake.

The Leverage Ratio

 The Basel III leverage ratio is defined as the capital measure ÷ the exposure measure.

  • Capital measure =  Tier 1 capital

  • Exposure measure = the sum of on-balance sheet exposures, off-balance sheet exposures, securities financing transaction exposures, and derivative exposures

  • Minimum Ratio = 3%

Conclusion

The Basel III framework was developed as a response to the global financial crisis and strengthened global banking regulation in a number of areas:

  • Improved quality of bank regulatory capital (focus on CET1)

  • Increased capital levels to give greater protection in times of stress

  • Enhanced risk capture for market risk, counterparty credit risk, and securitization

  • Implementation of capital buffers, both to reduce procyclicality and address externalities created by systemically important banks

  • Specification of a minimum leverage ratio to constrain excess leverage in the banking system

  • -Introduction of an international framework for mitigating excessive liquidity risk

The Basel III reforms of December 2017 have been designed to complement these improvements to the global regulatory framework and aim to establish greater risk sensitivity in the calculation of risk-weighted assets (RWAs) and enhance the comparability of banks’ capital ratios.

About the Author

Edward Bace, CFA, is a finance lecturer and professional specializing in training and consulting. He has extensive experience in finance, credit, and equity analysis, having worked for international financial and educational institutions including S&P, Lehman Brothers, CFA Institute, and Fitch. He currently  teaches banking and finance at Middlesex University in London. In addition to the  CFA charter, he possesses the MCSI and PGCHE qualifications, an MBA in Finance from NYU,  and a PhD from the University of Michigan.

Edward Bace