Basel III


Basel III is the third of three Basel Accords, a framework that sets international standards and minimums for bank capital requirements, stress tests, liquidity regulations, and leverage, with the goal of mitigating the risk of bank runs and bank failures. It was developed in response to the deficiencies in financial regulation revealed by the 2008 financial crisis and builds upon the standards of Basel II, introduced in 2004, and Basel I, introduced in 1988.
The Basel III requirements were published by the Basel Committee on Banking Supervision in 2010, and began to be implemented in major countries in 2012. Implementation of the Fundamental Review of the Trading Book, published and revised between 2013 and 2019, has been completed only in some countries and is scheduled to be completed in others in 2025 and 2026. Implementation of the Basel III: Finalising post-crisis reforms, introduced in 2017, was extended several times, and will be phased-in by 2028.

Key principles and requirements

CET1 capital requirements

Basel III requires banks to have a minimum CET1 ratio at all times of:
  • 4.5%
Plus:
  • A mandatory "capital conservation buffer" or "stress capital buffer requirement", equivalent to at least 2.5% of risk-weighted assets, but could be higher based on results from stress tests, as determined by national regulators.
Plus:
  • If necessary, as determined by national regulators, a "counter-cyclical buffer" of up to an additional 2.5% of RWA as capital during periods of high credit growth. This must be met by CET1 capital.
In the U.S., an additional 1% is required for globally systemically important financial institutions.
It also requires minimum Tier 1 capital of 6% at all times.
Common Tier 1 capital comprises shareholders equity, less deductions of accounting reserve that are not believed to be loss absorbing "today", including goodwill and other intangible assets. To prevent the potential of double-counting of capital across the economy, bank's holdings of other bank shares are also deducted.

Tier 2 capital requirements

+ Tier 1 capital is required to be above 8%.

Leverage ratio requirements

Leverage ratio is 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 securities financing transactions, and credit conversion factors for off-balance sheet items.
Basel III introduced a minimum leverage ratio of 3%.
The U.S. established another ratio, the supplemental leverage ratio, defined as Tier 1 capital divided by total assets. It is required to be above 3.0%. A minimum leverage ratio of 5% is required for large banks and systemically important financial institutions. Due to the COVID-19 pandemic, from April 2020 until 31 March 2021, for financial institutions with more than $250 billion in consolidated assets, the calculation excluded U.S. Treasury securities and deposits at Federal Reserve Banks.
In the EU, the minimum bank leverage ratio is the same 3% as required by Basel III.
The UK requires a minimum leverage ratio, for banks with deposits greater than £50 billion, of 3.25%. This higher minimum reflects the PRA's differing treatment of the leverage ratio, which excludes central bank reserves in 'Total exposure' of the calculation.

Liquidity requirements

Basel III introduced two required liquidity/funding ratios.

Liquidity coverage ratio

The liquidity coverage ratio requires banks to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days under a stressed scenario. This was implemented because some adequately-capitalized banks faced difficulties because of poor liquidity management. 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. Mathematically it is expressed as follows:
Regulators can allow banks to dip below their required liquidity levels per the liquidity coverage ratio during periods of stress.
Liquidity coverage ratio requirements for U.S. banks
In 2014, the Federal Reserve Board of Governors approved a U.S. version of the liquidity coverage ratio, which had 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. Bonds and securities issued by financial institutions, which can become illiquid during a financial crisis, are not eligible under the U.S. rule. The 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.

Net stable funding ratio

The Net stable funding ratio requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Counterparty risk: CCPs and SA-CCR

A new framework for exposures to CCPs was introduced in 2017.
The standardised approach for counterparty credit risk, which replaced the Current exposure method, became effective in 2017. SA-CCR is used to measure the potential future exposure of derivative transactions in the leverage exposure measure and non-modelled Risk Weighted Asset calculations.

Capital requirements for equity investments in funds

Capital requirements for equity investments in hedge funds, managed funds, and investment funds were introduced in 2017. The framework requires banks to take account of a fund's leverage when determining risk-based capital requirements associated with the investment and more appropriately reflecting the risk of the fund's underlying investments, including the use of a 1,250% risk weight for situations in which there is not sufficient transparency.

Limiting large exposure to external and internal counterparties

A framework for limiting large exposure to external and internal counterparties was implemented in 2018.
In the UK, as of 2024, the Bank of England was in the process of implementing the Basel III framework on large exposures.

Capital standards for securitisations

A revised securitisation framework, effective in 2018, aims to address shortcomings in the Basel II securitisation framework and to strengthen the capital standards for securitisations held on bank balance sheets. The frameworks addresses the calculation of minimum capital needs for securitisation exposures.
Basel III reclassifies physical gold from a Tier 3 asset to a Tier 1 asset.

Interest rate risk in the banking book

New standards for "interest rate risk in the banking book" became effective in 2023. Banks are required to calculate their exposures based on "economic value of equity" and "net interest income" under a set of prescribed interest rate shock scenarios. The standards thereby deal with the risks associated with a change in interest rates, including interest rate gaps, basis risk, yield curve risk, and option risk.
The bank's exposure to IRRBB is then equal to the largest negative change in EVE across all scenarios - in essence, the theoretical risk to the economic value of a bank's equity from a change in interest rates.
IRRBB falls under Pillar II.

Fundamental Review of the Trading Book

Following a Fundamental Review of the Trading Book, minimum capital requirements for market risk in the trading book are based on a better calibrated standardised approach or internal model approval for an expected shortfall measure rather than, under Basel II, value at risk.

Basel III: Finalising post-crisis reforms

The Basel III: Finalising post-crisis reforms standards cover further reforms in six areas:
  • standardised approach for credit risk
  • internal ratings based approach for credit risk
  • Credit valuation adjustment risk ;
  • Operational risk - A standardised approach for operational risk for a bank based on income and historical losses
  • Output floor - Replaces Basel II output floor with a more robust risk-sensitive floor and disclosure requirements
  • Finalised Leverage ratio framework - buffer for global systemically important banks, definitions and requirements, exposure measures for on-balance sheet exposures, derivatives, securities financing transactions and off-balance sheet items.

    Other principles and requirements

  • The quality, consistency, and transparency of the capital base was raised.
  • * Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings. This is subject to prudential deductions, including goodwill and intangible assets.
  • * Tier 2 capital: supplementary capital, however, the instruments were harmonised.
  • * Tier 3 capital was eliminated.
  • The risk coverage of the capital framework was strengthened.
  • * Promoted more integrated management of market and counterparty credit risk
  • * Added the credit valuation adjustment–risk due to deterioration in counterparty's credit rating
  • * Strengthened the capital requirements for counterparty credit exposures arising from banks' derivatives, repo and securities financing transactions
  • * Raised the capital buffers backing these exposures
  • * Reduced procyclicality and
  • * Provided additional incentives to move OTC derivative contracts to qualifying central counterparties. Where a bank acts as a clearing member of a central counterparty for its own purposes, a risk weight of 2% must be applied to the bank’s trade exposure to the central counterparty.
  • * Provided incentives to strengthen the risk management of counterparty credit exposures
  • * Raised counterparty credit risk management standards by including wrong way risk
  • A series of measures was introduced to promote the buildup of capital buffers in good times that can be drawn upon in periods of stress.
  • * Measures to address procyclicality:
  • ** Dampen excess cyclicality of the minimum capital requirement;
  • ** Promoted more forward looking provisions;
  • ** Conserved capital to build buffers at individual banks and the banking sector that can be used in stress; and
  • * Achieved 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 scenarios of widening yield spreads in recessions.
  • * Stronger provisioning practices :
  • ** Advocates a change in the accounting standards towards an expected loss approach.