Basel III

Basel III is the third installment of the Basel Accords, establishing global standards for bank capital adequacy, stress testing, and liquidity requirements. It builds on and replaces parts of the Basel II framework, introduced in response to regulatory shortcomings exposed by the 2007–2008 financial crisis. The main goal of Basel III is to reinforce banks’ financial stability by raising minimum capital requirements, increasing the holdings of high-quality liquid assets, and reducing excessive leverage.

Initially published by the Basel Committee on Banking Supervision in November 2010, Basel III was slated for implementation between 2013 and 2015. However, its rollout was repeatedly postponed, first to January 2022 and later to January 2023, largely due to delays brought on by the COVID-19 pandemic.

The regulations coming into effect in January 2023, including the Fundamental Review of the Trading Book (FRTB) and the Basel III: Finalising Post-Crisis Reforms, are sometimes informally referred to as Basel IV. Despite this, the Basel Committee maintains that these updates are not extensive enough to merit a new title, reaffirming that only three Basel Accords exist.

Basel III strengthens the regulatory framework laid out in Basel II by raising capital requirements for banks. It also introduces new regulations on liquidity and funding stability, aiming to reduce the risk of bank runs and ensure the long-term resilience of financial institutions.

CET1 Capital Requirements

Under the original Basel III framework established in 2010, banks are required to maintain a Common Equity Tier 1 (CET1) capital ratio of 4.5% of their risk-weighted assets (RWAs), an increase from the 2% requirement under Basel II. This minimum CET1 ratio must be consistently upheld by banks since 2015. The ratio is calculated as follows:

$\frac{\mathrm{CET1}}{\mathrm{RWAs}}\ge 4.5\%$

In addition to the CET1 requirement, the minimum Tier 1 capital ratio has increased from 4% in Basel II to 6%, effective in 2015. This 6% consists of 4.5% from CET1 and an additional 1.5% from Additional Tier 1 (AT1) capital.

CET1 capital is defined as shareholders’ equity, which includes audited profits, minus deductions for items considered non-loss-absorbing, such as goodwill and other intangible assets. To avoid double-counting capital, banks must also deduct their holdings of shares in other banks.

Additionally, Basel III introduced two capital buffers:

1. Capital Conservation Buffer: This mandatory buffer is set at 2.5% of risk-weighted assets, phased in from 2017 and fully effective by 2019.
2. Counter-Cyclical Buffer: This discretionary buffer allows national regulators to require up to an additional 2.5% of RWA as capital during periods of high credit growth, which must be met with CET1 capital.

Leverage Ratio

Basel III established a minimum leverage ratio, effective from 2018, based on a leverage exposure definition published in 2014. A revised definition and a buffer for globally systemically important banks (G-SIBs) will be implemented in 2023.

The leverage ratio is calculated by dividing Tier 1 capital by the bank’s total leverage exposure, which includes:

• On-balance sheet assets
• Add-ons for derivative exposures and securities financing transactions (SFTs)
• Credit conversion factors for off-balance sheet items

The leverage ratio serves as a backstop to the risk-based capital measures, with banks expected to maintain a leverage ratio exceeding 3% under Basel III.

$\frac{\mathrm{Tier\; 1\; Capital}}{\mathrm{Total\; Exposure}}\ge 3\%$

For typical mortgage lenders that manage low-risk-weighted assets, the leverage ratio often becomes the critical capital metric.

In 2013, the U.S. Federal Reserve announced that the minimum Basel III leverage ratio would be 5% for eight systemically important financial institutions (SIFIs) and 6% for their insured bank holding companies. In the EU, banks have been required to disclose their leverage ratios since 2015, but a binding requirement has not yet been enacted. The UK has its own leverage ratio regime, with a binding minimum of 3.25% for banks with deposits exceeding £50 billion, reflecting the Prudential Regulation Authority’s differing treatment of the leverage ratio, which excludes central bank reserves from the total exposure calculation.

Liquidity Requirements

Basel III introduced two essential liquidity and funding ratios:

1. Liquidity Coverage Ratio (LCR): This ratio mandates that banks maintain enough high-quality liquid assets to cover their total net cash outflows over a 30-day stressed scenario. The LCR is mathematically expressed as:

$\mathrm{LCR}=\frac{\mathrm{High\; Quality\; Liquid\; Assets}}{\mathrm{Total\; Net\; Liquidity\; Outflows\; over\; 30\; Days}}\ge 100\%$

2. Net Stable Funding Ratio (NSFR): This ratio requires banks to hold enough stable funding to exceed their required amount of stable funding over a one-year period of extended stress. It is represented as:

$\mathrm{NSFR}=\frac{\mathrm{Available\; Amount\; of\; Stable\; Funding}}{\mathrm{Required\; Amount\; of\; Stable\; Funding}}>100\%$