An Overview of Basel III Framework

Basel III is a crucial regulatory response to the financial crisis and a major step forward towards creating a stronger and safer financial system. Basel III was developed expressly to reduce both the frequency and intensity of financial crisis. Studies indicate that the accord will lower the very significant economic costs of crisis. Such benefits will not materialize however unless we fully and consistently implement it; any weakening of the standards or delay in implementing them will only hinder efforts to restore confidence in the financial system.

Basel III substantially raises the quality and quantity of capital with a greater focus on common equity. The capital needs to be of the highest quality to better absorb losses from shocks that could emanate from anywhere. Basel III also introduces a simple leverage ratio which will act as a backstop to the risk-based measure. Such a measure is critical to underpinning the whole regime and will provide a simple and easy to understand sanity check of the results produced by the risk-based framework.

Basel III uses capital buffers. The conservation buffer provides a strong incentive for banks to build up capital in good times, while the counter-cyclical buffer should help protect banks against the dangers of rapid credit growth which might be particularly relevant for emerging economies. On top of that Basel III introduces sound liquidity risk management principles and global liquidity standards that will help banks more effectively manage this risk and maintain adequate liquidity buffers.

Some major differences after Basel III are:

1. Risk Management and Corporate Governance

The crisis showed that existing risk management systems could not cope with unforeseen stresses. However, systems alone were not to blame. Sound governance was often lacking. The Basel Committee recommendations in this regard are very clear.

2. Better and More Capital

Basel III raises the level and quality of capital in the system. When the whole Basel III package is implemented, bank's common equity will need to be atleast 7% of risk-weighted assets. This compares to a Basel II level of 2% common equity. And that's before taking account of the changes to definitions and risk-weights which make the effective increase in capital even greater. The 7% figure includes a 2.5% capital conservation buffer which is designed to be drawn on in difficult times and among improvements in capturing risk. On the asset side something worth mentioning is the stronger treatment of risks related to securitization and contingent credit lines. But what about the rest of Tier 1 and Tier 2 capital which amounts to another 3.5% of risk-weighted assets. The truth is that during the crisis some of the regulatory capital did not work as intended and did not absorb losses. A number of distressed banks had to be rescued by the public sector injecting capital. This had the effect of supporting not only depositors but also the investors in regulatory capital instruments.

Consequently, Tier 2 capital instruments, mainly subordinated debt and in some cases noncommon equity Tier 1 instruments did not absorb losses incurred by banks that would have failed without public sector support. Insufficient effective capital and the weakness of resolution frameworks left public authorities the painful choice of either letting their institutions fail thereby further disrupting the financial system or rescuing them with public funds thereby socializing the losses and worsening moral hazard.

3. Systemic Risks

Basel III addresses systemic risk in its two dimensions, the time dimension mitigating procyclicality and a cross-sectional dimension mitigating interconnection and contagion risk. Supervisors will be able to impose a counter-cyclical buffer on their banking system when credit growth seems to be getting out of hand. They will be able to apply this equally to foreign and domestic banks. Additionally, a leverage ratio will limit banks' ability to accumulate leverage even if they are using it to purchase supposedly safe assets.

4. Liquidity Management

Before the crisis, many banks saw liquidity as a free good. They did not imagine that the entire markets could freeze up. Nor did they anticipate an extended period of illiquidity. When the crisis erupted central banks were forced to step in and provide money markets and banks with unprecedented amounts of liquidity to help stabilize the market. The crisis exposed a number of deficiencies in banks' liquidity risk management and risk profiles. Basel III tries to address these deficiencies. This is the first time there have been detailed global liquidity rules. We do not have the same experience and high quality data as we do for capital and a number of areas which require careful potential impact assessment were identified

For these reasons, the committee agreed to take a measured approach in adopting the standards in 2015 and 2018 and will assess the impact during an observation period. This may result in modification of some of the liquidity standards if the committee's assessments yield compelling evidence and analysis to support it.

The Basel Committee has begun studying any potential unintended impacts of the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), particularly as they relate to central bank operations, money markets and the broader financial system. To that end the Basel Committee is already evaluating these and other liquidity topics. In some cases, in close cooperation with other BIS groups such as the committee on global financial system and the committee on payment and settlement systems, and in close consultation with the industry.