Basel III Banking Reforms: What You Need to Know

The Basel III banking reforms aim to strengthen the regulation and supervision of banks globally, with the goal of improving their resilience and reducing the risk of financial crises.

The reforms were developed by the Basel Committee on Banking Supervision, a group of banking regulators from around the world, and were finalized in 2010.

The new rules are designed to increase the amount of capital that banks must hold against their assets, reducing the risk of bank failures and protecting depositors' funds.

Banks will be required to hold a minimum of 4.5% of their risk-weighted assets in common equity, up from the previous minimum of 2%.

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Liquidity and leverage are two crucial aspects of Basel III, designed to ensure the stability and resilience of the global banking system. The leverage ratio is a minimum capital requirement that banks must meet, calculated by dividing Tier 1 capital by leverage exposure.

Basel III introduced a minimum leverage ratio of 3%, while the U.S. requires a supplemental leverage ratio of 3.0% and a minimum of 5% for large banks and systemically important financial institutions. The EU also requires a minimum bank leverage ratio of 3%.

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Regulators have implemented various milestones to track the leverage ratio, including supervisory monitoring, parallel runs, and final adjustments. Here is a summary of the key milestones:

In addition to leverage, liquidity requirements are also crucial. Basel III introduced two required liquidity/funding ratios: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). The LCR requires banks to hold sufficient high-quality liquid assets to cover total net cash outflows over 30 days under a stressed scenario.

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The leverage ratio is a crucial metric for banks to ensure their stability and resilience. It's calculated by dividing Tier 1 capital by the bank's leverage exposure.

The leverage exposure is the sum of the exposures of all on-balance sheet assets, add-ons for derivative exposures, and credit conversion factors for off-balance sheet items. This calculation is the foundation of the leverage ratio.

Basel III introduced a minimum leverage ratio of 3% in an effort to strengthen bank regulations. This standard has been adopted by several countries, including the EU, which also requires a minimum leverage ratio of 3%.

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The U.S. has its own leverage ratio requirements, with a supplemental leverage ratio that requires banks to have Tier 1 capital divided by total assets above 3.0%. Large banks and systemically important financial institutions must meet a stricter minimum leverage ratio of 5%.

The UK also has a higher minimum leverage ratio of 3.25% for banks with deposits greater than £50 billion. This reflects the PRA's differing treatment of the leverage ratio, which excludes central bank reserves in 'Total exposure' of the calculation.

Here's a list of the minimum leverage ratios required by different countries and organizations:

The leverage ratio has been a mandatory part of Basel III requirements since 2018, after a series of parallel run periods and final adjustments.

Liquidity is a crucial aspect of banking, and it's essential to understand how banks manage their liquidity to avoid difficulties during financial crises.

Banks are required to hold sufficient high-quality liquid assets to cover their total net cash outflows over 30 days under a stressed scenario. This is known as the liquidity coverage ratio, or LCR.

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The LCR consists of two parts: the numerator is the value of high-quality liquid assets (HQLA), and the denominator consists of the total net cash outflows over a specified stress period. Mathematically, it's expressed as follows: HQLA / (total expected cash outflows - total expected cash inflows).

Regulators can allow banks to dip below their required liquidity levels per the LCR during periods of stress.

The Net Stable Funding Ratio (NSFR) requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

In the EU, the LCR was introduced in 2015 with a 60% requirement, increasing by 10 percentage points each year until 2019. In 2018, the NSFR was introduced, and in 2019, the LCR came into full effect with a 100% requirement.

Here's a brief timeline of liquidity requirements:

U.S. banks have a modified version of the LCR, with more stringent definitions of HQLA and total net cash outflows. Certain privately issued mortgage-backed securities are included in HQLA under Basel III but not under the U.S. rule.

Basel III emphasizes the importance of robust risk management practices. The quality, consistency, and transparency of the capital base have been raised to ensure financial institutions can absorb potential losses.

A key aspect of Basel III is strengthening the risk coverage of the capital framework. This means that financial institutions must have sufficient capital to cover potential risks, reducing the likelihood of a financial crisis.

To promote countercyclical buffers, measures have been introduced to encourage the buildup of capital buffers during good times. These buffers can be drawn upon in periods of stress, helping to mitigate the impact of economic downturns.

Here are some key measures introduced by Basel III to promote risk management:

CET1 capital requirements are a crucial aspect of risk management for banks. Basel III requires banks to have a minimum CET1 ratio of 4.5% at all times.

This ratio is calculated by dividing Common Tier 1 capital by risk-weighted assets (RWAs). In addition to this minimum requirement, banks must also meet a mandatory "capital conservation buffer" or "stress capital buffer requirement" of at least 2.5% of RWAs.

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The capital conservation buffer can be higher based on results from stress tests, as determined by national regulators. In the U.S., an additional 1% is required for globally systemically important financial institutions.

Common Tier 1 capital comprises shareholders' equity, including audited profits, less deductions of accounting reserves that are not believed to be loss-absorbing "today", including goodwill and other intangible assets. Bank's holdings of other bank shares are also deducted to prevent double-counting of capital.

Here's a breakdown of the CET1 capital requirements:

In summary, banks must maintain a strong CET1 capital ratio to ensure stability and resilience in times of stress.

Counterparty Risk: CCPs and SA-CCR is a critical aspect of risk management. A new framework for exposures to Central Counterparties (CCPs) was introduced in 2017.

This framework replaced the Current Exposure Method and became effective in the same year. SA-CCR, or the Standardised Approach for Counterparty Credit Risk, is used to measure the potential future exposure of derivative transactions.

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The SA-CCR is used in two key areas: the leverage exposure measure and non-modelled Risk Weighted Asset calculations. This new framework aims to provide a more accurate and consistent way of assessing counterparty risk.

For example, in the UK, the Bank of England is in the process of implementing the Basel III framework on large exposures, which was implemented in 2018. This framework aims to limit large exposure to external and internal counterparties.

Here are some key features of the SA-CCR:

Interest Rate Risk in the Banking Book is a critical aspect of risk management in the banking industry. New rules for interest rate risk in the banking book became effective in 2018.

Banks are required to calculate their exposures based on economic value of equity (EVE) under a set of prescribed interest rate shock scenarios. This change aimed to provide a more accurate assessment of interest rate risk.

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The EVE approach helps banks identify potential losses in their banking book due to changes in interest rates. This is a significant improvement over previous methods, which may have underestimated the risk.

Banks must now consider a range of interest rate scenarios to determine their potential losses. This includes both positive and negative interest rate shocks.

By using EVE, banks can better manage their interest rate risk and make more informed decisions about their investments and lending activities.

The Fundamental Review of the Trading Book is a significant change for banks. It's based on a more accurate standardised approach or internal model approval for expected shortfall measure, rather than value at risk.

Banks with large trading, market-making, wealth management, and investment banking operations will be hit harder by the new rules. This is because the operational and market risk provisions of the proposal are driving the increase in required capital for these activities.

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The new rules will affect banks with business models concentrated on lending less than those with large trading operations. Companies in the renewable energy business are particularly concerned about the proposed increase in capital requirements for certain types of lending.

The proposed increase in capital requirements for tax equity investments in renewable energy projects will dilute the effectiveness of tax incentives for reducing global warming.

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Securitisations have been a crucial aspect of risk management for banks. The revised securitisation framework, effective in 2018, aims to address shortcomings in the Basel II securitisation framework.

The framework strengthens the capital standards for securitisations held on bank balance sheets. This is a significant improvement over the previous standards.

Securitisation exposures are a key area of focus for the revised framework. The framework addresses the calculation of minimum capital needs for securitisation exposures.

A better understanding of capital needs is essential for effective risk management. By strengthening capital standards, banks can mitigate potential risks associated with securitisations.

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Operational risk refers to the risk of loss from inadequate or failed internal processes, people, and systems, or from external events, including rogue traders, fraud, and big fines for violating anti-money laundering or other laws.

The proposal to increase capital requirements for operational risk would affect banks with large businesses outside conventional lending, such as wealth management and other fee-generating businesses, the most.

Higher business volumes present more opportunities for operational risk to manifest, and the complexities associated with a higher business volume can give rise to gaps or other deficiencies in internal controls that result in operational losses.

Banks with higher overall business volume are larger and more complex, which likely results in exposure to higher operational risk.

The regulators measure operational risk by a "business indicator" based on the size, complexity, and specifics of a bank's lending, investing, and financing activities and by its history of operations-related losses.

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The proposal would require banks to earmark twice as much capital for operational risks than required by the stress tests, according to Fed Governor Christopher Waller.

Operational risk is an amorphous concept that encompasses a large and highly variable set of risks, ranging from fraud to bad behavior to overzealous enforcement agencies to cyber attacks to asteroids, as FDIC Vice Chair Travis Hill puts it.

Basel III is a set of regulatory reforms designed to make banks more resilient and stable. The reforms cover six key areas, including standardized approaches for credit risk and operational risk.

The Basel III reforms are not just limited to credit risk, but also cover other areas such as credit valuation adjustment risk and the leverage ratio framework. The final leverage ratio framework includes buffer requirements for global systemically important banks.

Regulators around the world are proposing further increases in required capital for banks, which could make them charge more for loans. The largest banks in the US would be affected the most, with some 37 banks holding more than three-quarters of all bank assets.

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The proposed changes would require banks to use a standard measure for calculating capital requirements, rather than their own internal models. This would be particularly challenging for banks with large trading and market-making operations.

Some industries, such as renewable energy, could be hit harder by the new rules, which would require banks to hold more capital for certain types of lending. Companies in these industries say the proposed increase would dilute the effectiveness of tax incentives for projects aimed at reducing global warming.

The Basel Committee on Banking Supervision is the primary global standard-setter for the prudential regulation of banks. The committee has no legal authority to impose minimum standards, but its recommendations are widely adopted by governments around the world.

Here are some key dates related to the Basel III reforms:

The implementation of Basel III was a gradual process that spanned several years. The Basel Committee on Banking Supervision (BCBS) released the final version of its "Supervisory Framework for Measuring and Controlling Large Exposures" in April 2014.

The BCBS also extended the implementation schedule to 2019 and broadened the definition of liquid assets in January 2013. This delay was further extended, and the implementation of the market risk framework was delayed from 2019 to 2022, and then again to July 1, 2025, with a three-year phase-in period.

In the United States, the Federal Reserve implemented the Basel III standards in the U.S. via a proposal first published in 2011. Final rules on the liquidity coverage ratio were published in 2014.

Here's a breakdown of the key milestones in the implementation of Basel III:

The implementation of Basel III was a complex process that involved several key milestones. The leverage ratio became a mandatory part of Basel III requirements in 2018, and the liquidity coverage ratio reached 100% in 2019.

The implementation of Basel III has been projected to have a negative impact on economic growth, with estimates ranging from -0.05% to -0.15% per year due to increased bank lending spreads.

According to a study by the OECD, this effect can be mitigated by a decrease in monetary policy rates of 30 to 80 basis points. However, a more recent study by PwC projected that the implementation of Basel III Endgame requirements would reduce economic growth in the U.S. by 56 basis points.

Higher capital requirements have also led to contractions in trading operations and the number of personnel employed on trading floors in the United States.

Here are some key statistics on the projected impact of Basel III:

The projected macroeconomic impact of Basel III implementation is a topic of interest. An OECD study released in 2011 projected that the medium-term impact on economic growth would be in the range of -0.05% to -0.15% per year due to increased bank lending spreads of 15 to as much as 50 basis points.

This impact can be negated by a decrease in monetary policy rates of 30 to 80 basis points, according to the OECD study. However, a study by PwC in June 2024 projected that the implementation of the Basel III Endgame requirements would reduce economic growth in the U.S. by 56 basis points via reduced returns to bank shareholders and increased costs to consumers and businesses.

In the United States, higher capital requirements resulted in contractions in trading operations and the number of personnel employed on trading floors.

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In the United States, banks have to meet certain liquidity requirements under the liquidity coverage ratio.

The Federal Reserve Board of Governors approved a U.S. version of the liquidity coverage ratio in 2014, which has more stringent definitions of high-quality liquid assets (HQLA) and total net cash outflows. Certain privately issued mortgage-backed securities are included in HQLA under Basel III but not under the U.S. rule.

Bonds and securities issued by financial institutions, which can become illiquid during a financial crisis, are not eligible under the U.S. rule. This rule is also modified for banks that do not have at least $250 billion in total assets or at least $10 billion in on-balance sheet foreign exposure.

Regulators are proposing changes to the liquidity requirements, which would increase the required highest-grade capital by about 16% on average, with a bigger increase imposed on the biggest banks. The largest banks would have to hold an additional 2 percentage points of capital, or an additional $2 of capital for every $100 of risk-weighted assets.

The proposal would change both the numerator and the denominator in the capital/risk-weighted assets calculation. It would apply the stiffest risk-based capital approach to more banks, those with $100 billion or more of assets, up from the current threshold of $700 billion.

Some 37 large banks in the U.S. would be covered, holding more than three-quarters of all bank assets in the U.S. Community banks and smaller regional banks wouldn’t be affected.

The regulators would require banks to have more capital for risks posed by trading activities and by operations, and require them to use standard models instead of internal ones to gauge these risks. These elements account for the bulk of the proposed increase in required capital.

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Here are the key changes proposed by regulators:

Regulators had planned to take comments until the end of November 2023, but banks asked for more time due to a lack of transparency and absence of data justifying the details. In response, regulators extended the comment period until January 16, 2024.

Banks are concerned that the proposed risk-based capital treatment for mortgage lending, tax credit investments, trading activities, and operational risk might overestimate the risk of these activities. Fed Vice Chair Barr has already expressed concerns about this issue.

Revisions to the proposal, particularly the operational risk and mortgage-lending provisions, are very likely. Gov. Waller has suggested that he might support the proposals if the operational risk provisions were scaled back.

Fed Chair Powell has stated that he expects broad and material changes to the proposal. He's confident that the final product will have broad support, both at the Fed and in the broader world.

The rules will be phased in over three years once they are final.

Banks decide for themselves how much capital to hold, but regulators require a certain amount to prevent failures and financial crises.

Banks with too little capital may take imprudent risks, and raising capital is more expensive than taking deposits or borrowing money.

Regulators are proposing to increase the minimum capital requirement for banks, known as the "Basel III Endgame", which is opposed by many big banks.

Operational risk refers to the risk of loss from inadequate or failed internal processes, people, and systems, or from external events like rogue traders, fraud, and big fines.

Operational risk is measured by a "business indicator" based on a bank's size, complexity, and history of operations-related losses.

Banks with large businesses outside conventional lending, such as wealth management and other fee-generating businesses, will be hit hardest by the new rules.

The proposal would require banks to earmark twice as much capital for operational risks than required by regular stress tests.

The Bank Policy Institute argues against penalizing banks for past operations-related losses, saying the new rules would disadvantage banks with business models that rely heavily on fees.

Companies in the renewable energy business say the proposed increase in capital requirements for certain types of lending will dilute the effectiveness of tax incentives for projects aimed at reducing global warming.

PwC's Our Take offers in-depth analysis on key developments shaping the industry as they happen in real-time. They cover the latest updates on Basel III reforms and other financial services risk & reg topics.

The changing regulatory landscape is a major focus area for Basel III, with PwC's Our Take providing timely insights.

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The proposal aims to increase the required highest-grade capital by about 16% on average, with a bigger increase imposed on the biggest banks. This means the largest banks would have to hold an additional 2 percentage points of capital, or an additional $2 of capital for every $100 of risk-weighted assets.

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The regulators are proposing to change the way banks calculate their capital requirements, which would affect 37 large banks in the US that hold more than three-quarters of all bank assets. These banks would have to use a standard measure instead of their own models for calculating capital requirements for loans.

The proposal would also require banks to have more capital for risks posed by trading activities and by operations. This would account for the bulk of the proposed increase in required capital.

One of the key changes is that banks would have to use standard models instead of internal ones to gauge risks. This would apply to banks with $100 billion or more in assets.

Here are some key points about the proposal:

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