Basel III norms are a new set of banking rules developed by the Basel Committee on Banking Supervision of BIS. The objective of the Basel III accord is to strengthen the regulation, supervision and risk management of the banking sector. The new rules prescribe how to assess risks, and how much capital to set aside for banks in keeping with their risk profile.

Basel III builds on the builds on the International Convergence of Capital Measurement and Capital Standards document (Basel II).

According to the BCBS, the Basel 3 proposals have two main objectives:

• To strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector; and
• To improve the banking sector’s ability to absorb shocks arising from financial and economic stress.

Summary of Changes in Basel III from Basel II

The most important changes in Basel III are listed below:

Increased Capital Requirements

The rules aim at improving both the quality and quantity of capital.

According to the Basel III rules, banks will need to increase their tier-one capital ratio (ratio of equity capital to risk-weighted assets (RWA)) from 2% to 4.5%. This should be done by 2015. In addition to this, by 2019, banks will be required to add an additional conservation buffer of 2.5%. This means that they will have to hold core capital equal to 7% of their risk-weighted assets.

The minimum total capital requirements has increased from 8% to 10.5% (including the conversation buffer)

There are also significant changes in what qualifies as Tier 1 capital. For example, common equity and retained earnings should form the predominant component of Tier I capital.

The reasoning behind this move is that if banks have higher capital cushion, they will be in a better position to take the effects of a downturn.

Reduced Leverage

The leverage limit for banks has been set to 3%, i.e., a bank’s total assets (including both on and off-balance sheet assets) should not be more than 33 times bank capital.

Liquidity Reforms

To complement its “Principles for Sound Liquidity ”Risk Management and Supervision, the Basel Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity:

• Increased Short-term Liquidity Coverage: Since Basel Committee expects many institutions to face a liquidity challenge, it has introduced new requirements for liquidity. A 30-day Liquidity Coverage Ratio is intended to ensure that banks have short-term resilience.

• Increased Long-term Balance Sheet Funding: The Net Stable Funding Ratio (NSFR) is designed to encourage banks to move towards a more stable structure by using more stable sources to fund their activities rather than depending on short term wholesale funding.

Capturing Risks

With Basel III, the objective of BCBS is to ensure that all the risks are fully covered in the Pillar 1 framework. It increases capital requirements for risks that were not adequately captured in the Basel 2 framework. Treatments of some of the exposures are listed below:

• Trading Book: Significant increases introduced in Basel 2.5 (July 2009) as implemented via CRD3
• Securitization: Significant increases introduced in Basel 2.5 (July 2009) as implemented via CRD3
• Exposures to financial institutions: Modified in Basel III and will be effective from 1 January 2013
• Counterparty risk on derivative exposures: Modified in Basel III and will be effective from 1 January 2013

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