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  • Basel III Basel III is a global, voluntary regulatory

  • standard on bank capital adequacy, stress testing and market liquidity risk. It was

  • agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and was

  • scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended

  • implementation until 31 March 2018. The third installment of the Basel Accords was developed

  • in response to the deficiencies in financial regulation revealed by the late-2000s financial

  • crisis. Basel III was supposed to strengthen bank capital requirements by increasing bank

  • liquidity and decreasing bank leverage. General Overview

  • Unlike Basel I and Basel II which are primarily related to the required level of bank loss

  • reserves that must be held by banks for various classes of loans and other investments and

  • assets that they have, Basel III is primarily related to the risks for the banks of a run

  • on the bank by requiring differing levels of reserves for different forms of bank deposits

  • and other borrowings. Therefore contrary to what might be expected by the name, Basel

  • III rules do not for the most part supersede the guidelines known as Basel I and Basel

  • II but work alongside them. Key principles

  • Capital requirements The original Basel III rule from 2010 was

  • supposed to require banks to hold 4.5% of common equity (up from 2% in Basel II) and

  • 6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets" (RWA). Basel

  • III introduced "ad æitional capital buffers", (i) a "mandatory capital conservation buffer"

  • of 2.5% and (ii) a "discretionary counter-cyclical buffer", which would allow national regulators

  • to require up to another 2.5% of capital during periods of high credit growth.

  • Leverage ratio Basel III introduced a minimum "leverage ratio".

  • The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total

  • consolidated assets; The banks were expected to maintain a leverage ratio in excess of

  • 3% under Basel III. In July 2013, the US Federal Reserve Bank announced that the minimum Basel

  • III leverage ratio would be 6% for 8 Systemically important financial institution (SIFI) banks

  • and 5% for their insured bank holding companies. Liquidity requirements

  • Basel III introduced two required liquidity ratios. The "Liquidity Coverage Ratio" was

  • supposed to require a bank to hold sufficient high-quality liquid assets to cover its total

  • net cash outflows over 30 days; the Net Stable Funding Ratio was to require the available

  • amount of stable funding to exceed the required amount of stable funding over a one-year period

  • of extended stress. US Version of the Basel Liquidity Coverage

  • Ratio Requirements On 24 October 2013, the Federal Reserve Board

  • of Governors approved an interagency proposal for the U.S. version of the Basel Committee

  • on Banking Supervision's (BCBS) Liquidity Coverage Ratio (LCR). The ratio would apply

  • to certain U.S. banking organizations and other systematically important financial institutions.

  • The comment period for the proposal is scheduled to close by 31 January 2014.

  • The U.S. LCR proposal came out significantly tougher than BCBS’s version, especially

  • for larger bank holding companies. The proposal requires financial institutions and FSOC designated

  • nonbank financial companies to have an adequate stock of High Quality Liquid Assets (HQLA)

  • that can be quickly liquidated to meet liquidity needs over a short period of time.

  • The LCR consists of two parts: the numerator is the value of HQLA, and the denominator

  • consists of the total net cash outflows over a specified stress period (total expected

  • cash outflows minus total expected cash inflows). The Liquidity Coverage Ratio applies to US

  • banking operations with assets of more than 10 billion. The proposal would require:

  • Large Bank Holding Companies (BHC) – those with over $250 billion in consolidated assets,

  • or more in on-balance sheet foreign exposure, and to systemically important, non-bank financial

  • institutions; to hold enough HQLA to cover 30 days of net cash outflow. That amount would

  • be determined based on the peak cumulative amount within the 30 day period.

  • Regional firms (those with between $50 and $250 billion in assets) would be subject to

  • a “modifiedLCR at the (BHC) level only. The modified LCR requires the regional firms

  • to hold enough HQLA to cover 21 days of net cash outflow. The net cash outflow parameters

  • are 70% of those applicable to the larger institutions and do not include the requirement

  • to calculate the peak cumulative outflows Smaller BHCs, those under $50 billion, would

  • remain subject to the prevailing qualitative supervisory framework.

  • The US proposal divides qualifying High Quality Liquid Assets into three specific categories

  • (Level 1, Level 2A, and Level 2B). Across the categories the combination of Level 2A

  • and 2B assets cannot exceed 40% HQLA with 2B assets limited to a maximum of 15% of HQLA.

  • Level 1 represents assets that are highly liquid (generally those risk-weighted at 0%

  • under the Basel III standardized approach for capital) and receive no haircut. Notably,

  • the Fed chose not to include GSE-issued securities in Level 1, despite industry lobbying, on

  • the basis that they are not guaranteed by the full faith and credit of the US government.

  • Level 2A assets generally include assets that would be subject to a 20% risk-weighting under

  • Basel III and includes assets such as GSE-issued and -guaranteed securities. These assets would

  • be subject to a 15% haircut which is similar to the treatment of such securities under

  • the BCBS version. Level 2B assets include corporate debt and

  • equity securities and are subject to a 50% haircut. The BCBS and US version treats equities

  • in a similar manner, but corporate debt under the BCBS version is split between 2A and 2B

  • based on public credit ratings, unlike the US proposal. This treatment of corporate debt

  • securities is the direct impact of DFA’s Section 939 (i.e., the removal of references

  • to credit ratings) and further evidences the conservative bias of US regulatorsapproach

  • to the LCR. The proposal requires that the LCR be at least

  • equal to or greater than 1.0 and includes a multiyear transition period that would require:

  • 80% compliance starting 1 January 2015, 90% compliance starting 1 January 2016, and 100%

  • compliance starting 1 January 2017. Lastly, the proposal requires both sets of

  • firms (large bank holding companies and regional firms) subject to the LCR requirements to

  • submit remediation plans to U.S. regulators to address what actions would be taken if

  • the LCR falls below 100% for three consecutive days or longer.

  • Implementation Summary of originally (2010) proposed changes

  • in Basel Committee language First, the quality, consistency, and transparency

  • of the capital base will be raised.

  • Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained

  • earnings Tier 2 capital: supplementary capital, however,

  • the instruments will be harmonised Tier 3 capital will be eliminated.

  • Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained

  • earnings Tier 2 capital: supplementary capital, however,

  • the instruments will be harmonised Tier 3 capital will be eliminated.

  • Second, the risk coverage of the capital framework will be strengthened.

  • Promote more integrated management of market and counterparty credit risk

  • Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit

  • rating Strengthen the capital requirements for counterparty

  • credit exposures arising from banks' derivatives, repo and securities financing transactions

  • Raise the capital buffers backing these exposures Reduce procyclicality and

  • Provide additional incentives to move OTC derivative contracts to qualifying central

  • counterparties (probably clearing houses). Currently, the BCBS has stated derivatives

  • cleared with a QCCP will be risk-weighted at 2% (The rule is still yet to be finalized

  • in the U.S.) Provide incentives to strengthen the risk

  • management of counterparty credit exposures Raise counterparty credit risk management

  • standards by including wrong-way risk Promote more integrated management of market

  • and counterparty credit risk Add the CVA (credit valuation adjustment)-risk

  • due to deterioration in counterparty's credit rating

  • Strengthen the capital requirements for counterparty credit exposures arising from banks' derivatives,

  • repo and securities financing transactions Raise the capital buffers backing these exposures

  • Reduce procyclicality and Provide additional incentives to move OTC

  • derivative contracts to qualifying central counterparties (probably clearing houses).

  • Currently, the BCBS has stated derivatives cleared with a QCCP will be risk-weighted

  • at 2% (The rule is still yet to be finalized in the U.S.)

  • Provide incentives to strengthen the risk management of counterparty credit exposures

  • Raise counterparty credit risk management standards by including wrong-way risk

  • Third, a leverage ratio will be introduced as a supplementary measure to the Basel II

  • risk-based framework,

  • intended to achieve the following objectives:

  • Put a floor under the build-up of leverage in the banking sector

  • Introduce additional safeguards against model risk and measurement error by supplementing

  • the risk based measure with a simpler measure that is based on gross exposures.

  • intended to achieve the following objectives:

  • Put a floor under the build-up of leverage in the banking sector

  • Introduce additional safeguards against model risk and measurement error by supplementing

  • the risk based measure with a simpler measure that is based on gross exposures.

  • Put a floor under the build-up of leverage in the banking sector

  • Introduce additional safeguards against model risk and measurement error by supplementing

  • the risk based measure with a simpler measure that is based on gross exposures.

  • Fourth, a series of measures is introduced to promote the build up of capital buffers

  • in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting

  • countercyclical buffers").

  • Measures to address procyclicality:

  • Dampen excess cyclicality of the minimum capital requirement;

  • Promote more forward looking provisions; Conserve capital to build buffers at individual

  • banks and the banking sector that can be used in stress; and

  • Achieve the broader macroprudential goal of protecting the banking sector from periods

  • of excess credit growth.

  • Requirement to use long term data horizons to estimate probabilities of default,

  • downturn loss-given-default estimates, recommended in Basel II, to become mandatory

  • Improved calibration of the risk functions, which convert loss estimates into regulatory

  • capital requirements. Banks must conduct stress tests that include

  • widening credit spreads in recessionary scenarios.

  • Promoting stronger provisioning practices (forward looking provisioning):

  • Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,

  • EL amount := LGD*PD*EAD). Measures to address procyclicality:

  • Dampen excess cyclicality of the minimum capital requirement;

  • Promote more forward looking provisions; Conserve capital to build buffers at individual

  • banks and the banking sector that can be used in stress; and

  • Dampen excess cyclicality of the minimum capital requirement;

  • Promote more forward looking provisions; Conserve capital to build buffers at individual

  • banks and the banking sector that can be used in stress; and

  • Achieve the broader macroprudential goal of protecting the banking sector from periods

  • of excess credit growth.

  • Requirement to use long term data horizons to estimate probabilities of default,

  • downturn loss-given-default estimates, recommended in Basel II, to become mandatory

  • Improved calibration of the risk functions, which convert loss estimates into regulatory

  • capital requirements. Banks must conduct stress tests that include

  • widening credit spreads in recessionary scenarios. Requirement to use long term data horizons

  • to estimate probabilities of default, downturn loss-given-default estimates, recommended

  • in Basel II, to become mandatory Improved calibration of the risk functions,

  • which convert loss estimates into regulatory capital requirements.

  • Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.

  • Promoting stronger provisioning practices (forward looking provisioning):

  • Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,

  • EL amount := LGD*PD*EAD). Advocating a change in the accounting standards

  • towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).

  • Fifth,a global minimum liquidity standard for internationally active banks is introduced

  • that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term

  • structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the

  • oversight panel of the Basel Committee on Banking Supervision issued a statement saying

  • that regulators will allow banks to dip below their required liquidity levels, the liquidity

  • coverage ratio, during periods of stress.) The Committee also is reviewing the need for

  • additional capital, liquidity or other supervisory measures to reduce the externalities created

  • by systemically important institutions. As of September 2010, proposed Basel III norms

  • asked for ratios as: 7–9.5% (4.5% + 2.5% (conservation buffer) + 0–2.5% (seasonal

  • buffer)) for common equity and 8.5–11% for Tier 1 capital and 10.5–13% for total capital.

  • On 15 April, the Basel Committee on Banking Supervision (“BCBS”) released the final

  • version of itsSupervisory Framework for Measuring and Controlling Large Exposures

  • (“SFLE”) that builds upon longstanding BCBS guidance on credit exposure concentrations.

  • U.S. implementation The U.S. Federal Reserve announced in December

  • 2011 that it would implement substantially all of the Basel III rules. It summarized

  • them as follows, and made clear they would apply not only to banks but also to all institutions

  • with more than US$50 billion in assets: "Risk-based capital and leverage requirements"

  • including first annual capital plans, conduct stress tests, and capital adequacy "including

  • a tier one common risk-based capital ratio greater than 5 percent, under both expected

  • and stressed conditions" – see scenario analysis on this. A risk-based capital surcharge

  • Market liquidity, first based on the US's own "interagency liquidity risk-management

  • guidance issued in March 2010" that require liquidity stress tests and set internal quantitative

  • limits, later moving to a full Basel III regime - see below.

  • The Federal Reserve Board itself would conduct tests annually "using three economic and financial

  • market scenarios." Institutions would be encouraged to use at least five scenarios reflecting

  • improbable events, and especially those considered impossible by management, but no standards

  • apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including

  • company-specific information, would be made public" but one or more internal company-run

  • stress tests must be run each year with summaries published.

  • Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a

  • single counterparty as a percentage of the firm's regulatory capital. Credit exposure

  • between the largest financial companies would be subject to a tighter limit."

  • "Early remediation requirements" to ensure that "financial weaknesses are addressed at

  • an early stage". One or more "triggers for remediationsuch as capital levels, stress

  • test results, and risk-management weaknessesin some cases calibrated to be forward-looking"

  • would be proposed by the Board in 2012. "Required actions would vary based on the severity of

  • the situation, but could include restrictions on growth, capital distributions, and executive

  • compensation, as well as capital raising or asset sales."

  • As of January 2014, the U.S. has been on track to implement many of the Basel III rules,

  • however differences remain in ratio requirements and calculations.

  • Key milestones Liquidity requirements

  • Analysis on Basel III impact Macroeconomic impact

  • An OECD study released on 17 February 2011, estimated that the medium-term impact of Basel

  • III implementation on GDP growth would be in the range of −0.05% to −0.15% per year.

  • Economic output would be mainly affected by an increase in bank lending spreads, as banks

  • pass a rise in bank funding costs, due to higher capital requirements, to their customers.

  • To meet the capital requirements originally effective in 2015 banks were estimated to

  • increase their lending spreads on average by about 15 basis points. Capital requirements

  • effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio)

  • could increase bank lending spreads by about 50 basis points. The estimated effects on

  • GDP growth assume no active response from monetary policy. To the extent that monetary

  • policy would no longer be constrained by the zero lower bound, the Basel III impact on

  • economic output could be offset by a reduction (or delayed increase) in monetary policy rates

  • by about 30 to 80 basis points. Critics

  • Think-tanks such as the World Pensions Council (WPC) have argued that Basel III merely builds

  • on and further expands the existing Basel II regulatory base, without questioning fundamentally

  • its core tenets, notably the ever-growing reliance on standardized assessments of "credit

  • risk" marketed by two private sector agencies- Moody's and S&P, thus using public policy

  • to strengthen anti-competitive duopolistic practices.

  • Basel III has also been criticized by banks, organized in the Institute of International

  • Finance in Washington D.C. (an international association of global banks) with the argument

  • that it would hurt them and economic growth. OECD estimated that implementation of Basel

  • III would decrease annual GDP growth by 0.05–0.15%, blaming regulation as responsible for slow

  • recovery from the late-2000s financial crisis. Basel III was also criticized as negatively

  • affecting the stability of the financial system by increasing incentives of banks to game

  • the regulatory framework. The American Banker's Association, community banks organized in

  • the Independent Community Bankers of America, and some of the most liberal Democrats in