In response to the 2007-2008 global financial crisis which highlighted a number of weaknesses of the Basel II framework, the Basel Committee for Banking Supervision (BCBS) proposed several reform measures, collectively known as Basel III, which build upon the Basel II requirements, focusing on strengthening the capital, supervision, risk management and risk disclosure of banks. Basel III reform measures were specifically aimed at addressing the causes leading to the 2007-2008 global financial crisis, as identified by the BCBS, such as excess liquidity, excess leverage, insufficient capitalization and inadequate liquidity buffers. In addition, the BCBS also recognized the systemic role of pro-cyclical deleveraging process and interconnectedness of financial institutions in exacerbating the adverse effects of the financial crisis, hence macro-prudential objectives were also taken into consideration under the Basel III framework.
The Basel Accord, known as Basel I, which is not an enforceable treaty but a series of recommendations regarding capital measurement and standards, was first introduced by the BCBS in 1988. It was progressively adopted by all the BCBS member countries and other countries with internationally-active banks. In response to the new developments in the financial markets and considerable economic turbulence in the financial system since the introduction of Basel I, the BCBS embarked on a modernization of the bank capital framework in June 1999 and published the Basel II framework in June 2004. Since its introduction in 2004, Basel II has undergone several changes. The most recent enhancement to the Basel II framework was the strengthening of risk measurement related to securitizations and resecuritizations exposures, extending capital charges for banking books to trading books and more stringent method for computing market risk in July 2009, known as Basel 2.5.
Evolving from the Basel II framework, the Basel III framework retains the “three pillars” approach – minimum capital requirements under Pillar 1, supervisory review under Pillar 2 and market discipline under Pillar 3. Under Pillar 1, in addition to credit risk, market risk and operational risk, the Basel III framework requires banks to address liquidity risk through a liquidity framework.
For the calculation of credit risk capital charges under Basel II, which concentrates on risks from banking book activities, banks are allowed to use either a standardized approach, as prescribed by the BCBS based on external credit assessment (ie: recognized credit rating agencies), or an internal ratings-based approach, subject to approval of supervisors. Under Basel III, the BCBS had adopted several enhanced measures to strengthen the credit risk measurement, coverage, capital requirements and standards of risk management practices.
Market risk capital charges concentrate on risks from trading book activities. Similar to the credit risk capital charges, banks are allowed to use either a standardized approach or an internal model approach for the calculation. Based on the Basel Committee/ IOSCO Agreement in July 2005, the BCBS had further enhanced the Basel II market risk framework in July 2009 (known as Basel 2.5) and December 2009, by strengthening the risk measurement methodology on incremental risk (default and migration risk) and the associated capital charges on both securitized and unsecuritized products.
The operational risk under Basel II takes into account the risks of loss resulting from inadequate or failed internal processes, people and systems or from external events, these includes legal and regulatory risks, but exclude strategic and reputational risks. Banks are allowed to use one of the three methods for the calculation of capital charges under Basel II, representing a continuum of increasing sophistication and risk-sensitivity – (i) basic indicator approach; (ii) standardized approach; or (iii) advanced measurement approach (AMA). This approach continues to be relevant under the Basel III framework.
Recognizing the importance of sound liquidity management, the BCBS has introduced the measurement, standards and monitoring of liquidity risk under the Basel III framework. Under the liquidity framework, the BCBS specifies two minimum liquidity requirements – (i) the liquidity coverage ratio (LCR), a short-term liquidity ratio defined as the stock of high quality liquid assets over total net cash outflows over a 30-day period, of at least 100% and (ii) the net stable funding ratio (NSFR), which addresses structural maturity mismatches and is defined as the available amount of stable funding (such as equity or liabilities with a maturity horizon over one year) over the required amount of stable funding (such as encumbered, less liquid assets), of at least 100%.
Other Enhancements under Basel III
Tightening Definition of Capital
Basel III tightens the definition of capital by eliminating Tier 3 capital (originally used to cover market risk), harmonizing eligibility of Tier 2 capital instruments and de-recognizing innovative hybrid capital instruments with step-up clauses from the Tier 1 and Tier 2 capital base. Banks will ultimately be required to maintain a minimum 4.5% core Tier 1 ratio (up from 2%) and 6% Tier 1 ratio (up from 4%).
Basel III also introduces several measures aimed at addressing the pro-cyclical effects of the capital requirements, including a capital conservation buffer requirement (for all banks) and countercyclical capital buffer (to be implemented during periods of excessive credit growth, as determined by the national authorities).
Another proposed counter-cyclical measure is the leverage ratio, defined as total capital (sum of Tier 1 and Tier 2 capital) over total exposure (sum of on-balance sheet and off-balance sheet exposure with credit conversion factor). This is to prevent excessive leverage during boom periods; post-crisis system-wide deleveraging often exacerbates the adverse effects of a downturn on asset valuations and macroeconomic stability.
Surcharge for Systemically-Important Financial Institutions (SIFIs)
Basel III requires an additional capital surcharge of 1-2.5%, to be met through common equity of the financial institutions that are deemed to be too big to fail.
Timeline for Implementation
The target date for full implementation of Basel III is January 1, 2019. The enhanced core Tier 1 ratio and total capital ratio will be phased-in between January 2013 and January 2015 while additional capital requirements from the capital conservation buffer will be phased-in between January 2016 and January 2019. The reform measures to the counterparty risk framework, including the extension of capital charges to the trading book, enhanced capital charges for counterparty credit risk and use of stressed-VAR for computation of market risk will be effective as of January 1, 2013. For the minimum liquidity requirements, the BCBS will introduce the final version of the LCR and NSFR requirements on January 1, 2015 and January 1, 2018 respectively, but the observation period will begin in January 2012. For the leverage ratio requirement, the BCBS will be testing a minimum Tier 1 leverage ratio of 3% from January 2013 to January 2017, with the final version to be introduced on January 1, 2018. The BCBS will also phase-in the SIFI capital surcharges between January 2016 and January 2019.