Sunday, September 25, 2011

Basel Accords for Banks- Basel III

BASEL III is a new global regulatory standard on bank capital adequacy and liquidity agreed by the members of the Basel Committee on Banking Supervision. The third of the Basel Accords was developed in a response to the deficiencies in financial regulation revealed by the global financial crisis

Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. 

The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.


Basel III will 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 also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth.

In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Summary of proposed changes

  • 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 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 central counterparties (probably clearing houses)
    • Provide incentives to strengthen the risk management of counterparty credit exposures
    • Raise counterparty credit risk management standards also by including the wrong-way risk
  • Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework.
    • The Committee therefore is introducing a leverage ratio requirement that is 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.
  • Fourth, the Committee is introducing a series of measures 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").
    • The Committee is introducing a series of measures to address procyclicality:
      • Dampen any 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).
  • Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio.
  • 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 on Sept 2010, Proposed Basel III norms ask 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 cap and 10.5 to 13 for total capital(Proposed Basel III Guidelines: A Credit Positive for Indian Banks)'


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