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Basel III Basel III is a global, voluntary regulatory
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standard on bank capital adequacy, stress testing and market liquidity risk. It was
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agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and was
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scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended
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implementation until 31 March 2018. The third installment of the Basel Accords was developed
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in response to the deficiencies in financial regulation revealed by the late-2000s financial
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crisis. Basel III was supposed to strengthen bank capital requirements by increasing bank
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liquidity and decreasing bank leverage. General Overview
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Unlike Basel I and Basel II which are primarily related to the required level of bank loss
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reserves that must be held by banks for various classes of loans and other investments and
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assets that they have, Basel III is primarily related to the risks for the banks of a run
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on the bank by requiring differing levels of reserves for different forms of bank deposits
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and other borrowings. Therefore contrary to what might be expected by the name, Basel
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III rules do not for the most part supersede the guidelines known as Basel I and Basel
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II but work alongside them. Key principles
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Capital requirements The original Basel III rule from 2010 was
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supposed to require banks to hold 4.5% of common equity (up from 2% in Basel II) and
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6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets" (RWA). Basel
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III introduced "ad æitional capital buffers", (i) a "mandatory capital conservation buffer"
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of 2.5% and (ii) a "discretionary counter-cyclical buffer", which would allow national regulators
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to require up to another 2.5% of capital during periods of high credit growth.
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Leverage ratio Basel III introduced a minimum "leverage ratio".
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The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total
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consolidated assets; The banks were expected to maintain a leverage ratio in excess of
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3% under Basel III. In July 2013, the US Federal Reserve Bank announced that the minimum Basel
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III leverage ratio would be 6% for 8 Systemically important financial institution (SIFI) banks
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and 5% for their insured bank holding companies. Liquidity requirements
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Basel III introduced two required liquidity ratios. The "Liquidity Coverage Ratio" was
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supposed to require a bank to hold sufficient high-quality liquid assets to cover its total
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net cash outflows over 30 days; the Net Stable Funding Ratio was to require the available
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amount of stable funding to exceed the required amount of stable funding over a one-year period
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of extended stress. US Version of the Basel Liquidity Coverage
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Ratio Requirements On 24 October 2013, the Federal Reserve Board
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of Governors approved an interagency proposal for the U.S. version of the Basel Committee
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on Banking Supervision's (BCBS) Liquidity Coverage Ratio (LCR). The ratio would apply
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to certain U.S. banking organizations and other systematically important financial institutions.
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The comment period for the proposal is scheduled to close by 31 January 2014.
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The U.S. LCR proposal came out significantly tougher than BCBS’s version, especially
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for larger bank holding companies. The proposal requires financial institutions and FSOC designated
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nonbank financial companies to have an adequate stock of High Quality Liquid Assets (HQLA)
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that can be quickly liquidated to meet liquidity needs over a short period of time.
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The LCR consists of two parts: the numerator is the value of HQLA, and the denominator
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consists of the total net cash outflows over a specified stress period (total expected
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cash outflows minus total expected cash inflows). The Liquidity Coverage Ratio applies to US
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banking operations with assets of more than 10 billion. The proposal would require:
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Large Bank Holding Companies (BHC) – those with over $250 billion in consolidated assets,
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or more in on-balance sheet foreign exposure, and to systemically important, non-bank financial
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institutions; to hold enough HQLA to cover 30 days of net cash outflow. That amount would
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be determined based on the peak cumulative amount within the 30 day period.
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Regional firms (those with between $50 and $250 billion in assets) would be subject to
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a “modified” LCR at the (BHC) level only. The modified LCR requires the regional firms
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to hold enough HQLA to cover 21 days of net cash outflow. The net cash outflow parameters
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are 70% of those applicable to the larger institutions and do not include the requirement
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to calculate the peak cumulative outflows Smaller BHCs, those under $50 billion, would
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remain subject to the prevailing qualitative supervisory framework.
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The US proposal divides qualifying High Quality Liquid Assets into three specific categories
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(Level 1, Level 2A, and Level 2B). Across the categories the combination of Level 2A
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and 2B assets cannot exceed 40% HQLA with 2B assets limited to a maximum of 15% of HQLA.
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Level 1 represents assets that are highly liquid (generally those risk-weighted at 0%
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under the Basel III standardized approach for capital) and receive no haircut. Notably,
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the Fed chose not to include GSE-issued securities in Level 1, despite industry lobbying, on
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the basis that they are not guaranteed by the full faith and credit of the US government.
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Level 2A assets generally include assets that would be subject to a 20% risk-weighting under
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Basel III and includes assets such as GSE-issued and -guaranteed securities. These assets would
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be subject to a 15% haircut which is similar to the treatment of such securities under
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the BCBS version. Level 2B assets include corporate debt and
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equity securities and are subject to a 50% haircut. The BCBS and US version treats equities
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in a similar manner, but corporate debt under the BCBS version is split between 2A and 2B
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based on public credit ratings, unlike the US proposal. This treatment of corporate debt
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securities is the direct impact of DFA’s Section 939 (i.e., the removal of references
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to credit ratings) and further evidences the conservative bias of US regulators’ approach
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to the LCR. The proposal requires that the LCR be at least
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equal to or greater than 1.0 and includes a multiyear transition period that would require:
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80% compliance starting 1 January 2015, 90% compliance starting 1 January 2016, and 100%
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compliance starting 1 January 2017. Lastly, the proposal requires both sets of
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firms (large bank holding companies and regional firms) subject to the LCR requirements to
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submit remediation plans to U.S. regulators to address what actions would be taken if
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the LCR falls below 100% for three consecutive days or longer.
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Implementation Summary of originally (2010) proposed changes
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in Basel Committee language First, the quality, consistency, and transparency
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of the capital base will be raised.
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Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained
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earnings Tier 2 capital: supplementary capital, however,
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the instruments will be harmonised Tier 3 capital will be eliminated.
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Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained
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earnings Tier 2 capital: supplementary capital, however,
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the instruments will be harmonised Tier 3 capital will be eliminated.
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Second, the risk coverage of the capital framework will be strengthened.
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Promote more integrated management of market and counterparty credit risk
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Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit
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rating Strengthen the capital requirements for counterparty
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credit exposures arising from banks' derivatives, repo and securities financing transactions
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Raise the capital buffers backing these exposures Reduce procyclicality and
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Provide additional incentives to move OTC derivative contracts to qualifying central
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counterparties (probably clearing houses). Currently, the BCBS has stated derivatives
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cleared with a QCCP will be risk-weighted at 2% (The rule is still yet to be finalized
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in the U.S.) Provide incentives to strengthen the risk
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management of counterparty credit exposures Raise counterparty credit risk management
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standards by including wrong-way risk Promote more integrated management of market
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and counterparty credit risk Add the CVA (credit valuation adjustment)-risk
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due to deterioration in counterparty's credit rating
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Strengthen the capital requirements for counterparty credit exposures arising from banks' derivatives,
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repo and securities financing transactions Raise the capital buffers backing these exposures
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Reduce procyclicality and Provide additional incentives to move OTC
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derivative contracts to qualifying central counterparties (probably clearing houses).
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Currently, the BCBS has stated derivatives cleared with a QCCP will be risk-weighted
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at 2% (The rule is still yet to be finalized in the U.S.)
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Provide incentives to strengthen the risk management of counterparty credit exposures
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Raise counterparty credit risk management standards by including wrong-way risk
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Third, a leverage ratio will be introduced as a supplementary measure to the Basel II
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risk-based framework,
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intended to achieve the following objectives:
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Put a floor under the build-up of leverage in the banking sector
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Introduce additional safeguards against model risk and measurement error by supplementing
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the risk based measure with a simpler measure that is based on gross exposures.
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intended to achieve the following objectives:
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Put a floor under the build-up of leverage in the banking sector
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Introduce additional safeguards against model risk and measurement error by supplementing
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the risk based measure with a simpler measure that is based on gross exposures.
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Put a floor under the build-up of leverage in the banking sector
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Introduce additional safeguards against model risk and measurement error by supplementing
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the risk based measure with a simpler measure that is based on gross exposures.
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Fourth, a series of measures is introduced to promote the build up of capital buffers
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in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting
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countercyclical buffers").
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Measures to address procyclicality:
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Dampen excess cyclicality of the minimum capital requirement;
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Promote more forward looking provisions; Conserve capital to build buffers at individual
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banks and the banking sector that can be used in stress; and
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Achieve the broader macroprudential goal of protecting the banking sector from periods
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of excess credit growth.
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Requirement to use long term data horizons to estimate probabilities of default,
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downturn loss-given-default estimates, recommended in Basel II, to become mandatory
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Improved calibration of the risk functions, which convert loss estimates into regulatory
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capital requirements. Banks must conduct stress tests that include
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widening credit spreads in recessionary scenarios.
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Promoting stronger provisioning practices (forward looking provisioning):
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Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,
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EL amount := LGD*PD*EAD). Measures to address procyclicality:
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Dampen excess cyclicality of the minimum capital requirement;
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Promote more forward looking provisions; Conserve capital to build buffers at individual
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banks and the banking sector that can be used in stress; and
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Dampen excess cyclicality of the minimum capital requirement;
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Promote more forward looking provisions; Conserve capital to build buffers at individual
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banks and the banking sector that can be used in stress; and
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Achieve the broader macroprudential goal of protecting the banking sector from periods
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of excess credit growth.
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Requirement to use long term data horizons to estimate probabilities of default,
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downturn loss-given-default estimates, recommended in Basel II, to become mandatory
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Improved calibration of the risk functions, which convert loss estimates into regulatory
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capital requirements. Banks must conduct stress tests that include
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widening credit spreads in recessionary scenarios. Requirement to use long term data horizons
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to estimate probabilities of default, downturn loss-given-default estimates, recommended
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in Basel II, to become mandatory Improved calibration of the risk functions,
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which convert loss estimates into regulatory capital requirements.
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Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.
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Promoting stronger provisioning practices (forward looking provisioning):
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Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,
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EL amount := LGD*PD*EAD). Advocating a change in the accounting standards
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towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).
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Fifth,a global minimum liquidity standard for internationally active banks is introduced
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that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term
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structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the
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oversight panel of the Basel Committee on Banking Supervision issued a statement saying
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that regulators will allow banks to dip below their required liquidity levels, the liquidity
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coverage ratio, during periods of stress.) The Committee also is reviewing the need for
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additional capital, liquidity or other supervisory measures to reduce the externalities created
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by systemically important institutions. As of September 2010, proposed Basel III norms
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asked for ratios as: 7–9.5% (4.5% + 2.5% (conservation buffer) + 0–2.5% (seasonal
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buffer)) for common equity and 8.5–11% for Tier 1 capital and 10.5–13% for total capital.
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On 15 April, the Basel Committee on Banking Supervision (“BCBS”) released the final
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version of its “Supervisory Framework for Measuring and Controlling Large Exposures”
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(“SFLE”) that builds upon longstanding BCBS guidance on credit exposure concentrations.
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U.S. implementation The U.S. Federal Reserve announced in December
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2011 that it would implement substantially all of the Basel III rules. It summarized
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them as follows, and made clear they would apply not only to banks but also to all institutions
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with more than US$50 billion in assets: "Risk-based capital and leverage requirements"
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including first annual capital plans, conduct stress tests, and capital adequacy "including
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a tier one common risk-based capital ratio greater than 5 percent, under both expected
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and stressed conditions" – see scenario analysis on this. A risk-based capital surcharge
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Market liquidity, first based on the US's own "interagency liquidity risk-management
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guidance issued in March 2010" that require liquidity stress tests and set internal quantitative
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limits, later moving to a full Basel III regime - see below.
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The Federal Reserve Board itself would conduct tests annually "using three economic and financial
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market scenarios." Institutions would be encouraged to use at least five scenarios reflecting
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improbable events, and especially those considered impossible by management, but no standards
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apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including
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company-specific information, would be made public" but one or more internal company-run
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stress tests must be run each year with summaries published.
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Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a
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single counterparty as a percentage of the firm's regulatory capital. Credit exposure
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between the largest financial companies would be subject to a tighter limit."
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"Early remediation requirements" to ensure that "financial weaknesses are addressed at
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an early stage". One or more "triggers for remediation—such as capital levels, stress
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test results, and risk-management weaknesses—in some cases calibrated to be forward-looking"
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would be proposed by the Board in 2012. "Required actions would vary based on the severity of
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the situation, but could include restrictions on growth, capital distributions, and executive
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compensation, as well as capital raising or asset sales."
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As of January 2014, the U.S. has been on track to implement many of the Basel III rules,
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however differences remain in ratio requirements and calculations.
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Key milestones Liquidity requirements
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Analysis on Basel III impact Macroeconomic impact
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An OECD study released on 17 February 2011, estimated that the medium-term impact of Basel
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III implementation on GDP growth would be in the range of −0.05% to −0.15% per year.
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Economic output would be mainly affected by an increase in bank lending spreads, as banks
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pass a rise in bank funding costs, due to higher capital requirements, to their customers.
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To meet the capital requirements originally effective in 2015 banks were estimated to
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increase their lending spreads on average by about 15 basis points. Capital requirements
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effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio)
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could increase bank lending spreads by about 50 basis points. The estimated effects on
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GDP growth assume no active response from monetary policy. To the extent that monetary
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policy would no longer be constrained by the zero lower bound, the Basel III impact on
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economic output could be offset by a reduction (or delayed increase) in monetary policy rates
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by about 30 to 80 basis points. Critics
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Think-tanks such as the World Pensions Council (WPC) have argued that Basel III merely builds
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on and further expands the existing Basel II regulatory base, without questioning fundamentally
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its core tenets, notably the ever-growing reliance on standardized assessments of "credit
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risk" marketed by two private sector agencies- Moody's and S&P, thus using public policy
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to strengthen anti-competitive duopolistic practices.
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Basel III has also been criticized by banks, organized in the Institute of International
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Finance in Washington D.C. (an international association of global banks) with the argument
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that it would hurt them and economic growth. OECD estimated that implementation of Basel
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III would decrease annual GDP growth by 0.05–0.15%, blaming regulation as responsible for slow
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recovery from the late-2000s financial crisis. Basel III was also criticized as negatively
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affecting the stability of the financial system by increasing incentives of banks to game
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the regulatory framework. The American Banker's Association, community banks organized in