Basel Three: Introduction and Development

 

 ......CONTINUATION FROM BASEL FRAMEWORK SUMMARY

2013 Onward: Basel III

Between 2010 and 2012, the BCBS published several documents that set out the key elements of Basel III. The requirements entered into force in 2013, but with extended transitional arrangements in many cases.

Most of Basel III took the form of enhancements or amendments to Basel II/Basel 2.5, much of which was retained. The areas addressed by Basel III included capital standards, leverage and liquidity ratios, and globally systemically important banks (G-SIBs).
Phase-in arrangements allowed banks until January 2019 to fully implement Basel III (with a few exceptions). There were two main reasons for this. First, banks were in recovery mode following the crisis and it took time to deleverage/de-risk balance sheets, raise new capital, revamps business strategies, and enhance risk management capabilities. Second, some aspects of the new requirements, notably about the leverage and liquidity ratios, were not finalized until after 2013.

In practice, many banks adopted Basel III quite quickly, particularly those less affected by the financial crisis as well as those in major economies. Others were slower to comply. Implementation has not yet been achieved – banks in some African countries, for example, are still operating to Basel II requirements or local variants.

To address several issues that were not finalized when Basel III requirements were first set out, as well as issues that emerged during implementation, the BCBS published some final changes to Basel III in December 2017. These are subject to phase-in arrangements that stretch out to 2027.

Context & Background to Basel III

Three Pillars Framework

Basel, I set minimum capital requirements for credit risk, with market risk added in the mid-1990s. The simple nature of this framework was useful for implementation, but the degree of latitude afforded to local regulators resulted in inconsistent application of rules in different jurisdictions. Further, the increase in the size and complexity of banks and financial products gave rise to new risks that were not covered by Basel I, while a lack of transparency made it difficult for third parties to determine the risk of lending to individual banks.

These and other issues led to the development of the three pillars framework in Basel II, which was retained in Basel III (with some changes to address weaknesses evident from the financial crisis).

Pillar 1: Minimum Capital Requirements: Pillar 1 focuses on the minimum capital requirements that banks must hold to cover their exposure to credit, market, and operational risk.

Pillar 2: Supervisory Review: Pillar 2 obliges banks to assess their compliance with capital adequacy requirements. Supervisors then review and challenge such assessments.

Pillar 3: Market Discipline: Pillar 3 requires banks to publish information about their risk exposures, capital adequacy, and risk management practices.

Pillar 1 (Minimum Capital Requirements)

Capital Adequacy

A principal aim of the Basel, requirements are to improve the capital adequacy of banks. The basic measure of this is the CAR. The formula is:

CAR = Regulatory Capital/ RWAs

Where:

• Regulatory capital consists of a bank’s Tier 1 capital as well as its Tier 2 capital. These are defined shortly.

• RWAs (risk-weighted assets), is an absolute measure of a bank’s exposures adjusted for risk.

The resulting percentage is compared to the minimum CAR of 8% to confirm that a bank meets, or exceeds, regulatory requirements.

The CAR under Pillar 1 covers credit, market, and operational risk. Different measurement methods are applied to each risk type, so the aggregate position is only determined once separate values are calculated for each risk type. Any risks that might result in inaccurate output values (for example, model risk) must be assessed under Pillar 2 and could result in a capital add-on.

Minimum Capital Ratios

The core minimum CAR of 8%, also known as the total capital ratio, has remained unchanged since Basel I. But this is not the only capital ratio that banks must meet. A minimum CET1 ratio was set at 4.5%, while total Tier 1 capital must be at least 6%.

Basel III also introduced two capital add-ons or “buffers.”

• The capital conservation buffer is an additional amount of common equity intended to constrain the weakening of a bank’s capital adequacy due to, for example, making dividend distributions or undertaking stock buybacks.

• The countercyclical buffer can be used by local supervisors to increase the capital conservation buffer. It is intended to limit pro-cyclical effects and meet the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth.

Credit Risk

Credit risk accounts for the bulk of most banks’ risk-taking activities and, therefore, their regulatory capital requirements. There are different approaches that banks can use when calculating RWAs for credit risk exposures.

Standardized Approach (SA)

Under the SA, the risk weights used are supplied by supervisors based on broad-brush categories differentiated by customer types/products (also known as exposure classes) and credit ratings or other criteria.

Revisions to the SA were included as part of the final Basel III rules published in December 2017. These revisions introduced more granularity and risk sensitivity and reduced the reliance on external credit ratings.

The SA is used by the majority of banks around the world, with even the most sophisticated institutions using it for risk exposures that do not warrant the cost or for which it is not possible to develop meaningful models (such as new products with no data history).

Pillar 2 (Supervisory Review)

Purpose of Pillar 2

The focus of Pillar 2 is on ensuring that banks have adequate capital to cover the material risks to which they are exposed. More specifically, these are:

• Risks that may impact Pillar 1 capital calculations (for example, model risk)

• Risks not covered under Pillar 1 (for example, liquidity risk)

Regulators expect that, through a better understanding of these risks and ensuring that banks hold adequate capital, the probability of a repeat financial crisis is reduced. Further, if a crisis were to occur, it is expected that any impact would be much lower. This requires banks to not only adhere to Basel III requirements but also have better risk management.
To meet Pillar 2 requirements, banks must demonstrate that they take an integrated firm-wide perspective of their risk exposures and have a sound risk management framework in place that has:

• Active board and senior management oversight

• Appropriate policies, procedures, and limits that align with the overall risk appetite set by the board

• Comprehensive and timely identification, measurement, mitigation, monitoring, and reporting of risks

• Appropriate management information systems (MIS)

• Comprehensive internal controls

Under Pillar 2, banks are required to prepare and submit their own assessment of risks and capital adequacy (ICAAP – internal capital adequacy assessment process). This is then subject to supervisory oversight and challenge (SREP). When reviewing and assessing a bank’s ICAAP, regulators consider not only the nature and size of the risks identified but also the soundness of a bank’s risk management and the sufficiency of its capital resources under stress conditions.

Pillar 2: Key Principles

Pillar 2 revolves around four key principles relating to the responsibilities of banks and supervisors.

Principle 1: ICAAP: Banks should have a process for assessing their overall capital adequacy about their risk profile and a strategy for maintaining their capital levels.

Principle 2: SREP: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

Principle 3: Minimum Capital Ratios: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital over the minimum.

Principle 4: Supervisory Intervention : Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Pillar 3 (Market Discipline)

Purpose of Pillar 3

Pillar 3 aims to promote market discipline through regulatory disclosure requirements. The provision of meaningful risk information to market participants is a fundamental element of a sound banking system as it reduces information asymmetry and promotes comparability of banks’ risk profiles.

The rationale for requiring greater transparency and disclosure under Pillar 3 is explained by the BCBS as follows:

These requirements enable market participants to access key information relating to a bank’s regulatory capital and risk exposures in order to increase transparency and confidence about a bank’s exposure to risk and the overall adequacy of its regulatory capital.

–Revised Pillar 3 disclosure requirements, BCBS, January 2015

In this context, disclosure refers to making information available to the public about a bank’s activities, risks, and performance. Such information is provided by documents such as annual reports and/or separate Pillar 3 reports.

Note that Pillar 3 disclosures are a supplement – rather than an alternative for –disclosures made as a result of accounting regimes or other mandatory requirements such as stock exchange listing rules.

Pillar 3: Guiding Principles

The BCBS set out five guiding principles for banks’ Pillar 3 disclosures.

Principle 1: Disclosures should be clear: Disclosures should be presented in a form that is understandable to key stakeholders and communicated through an accessible medium.

Principle 2: Disclosures should be comprehensive : Disclosures should describe a bank’s main activities and all significant risks, supported by relevant underlying data and information. Significant changes in risk exposures between reporting periods should be described, together with the appropriate response by management.

Disclosures should provide sufficiently information in both qualitative and quantitative terms on a bank’s processes and procedures for identifying, measuring, and managing those risks.

Principle 3: Disclosures should be meaningful to users: Disclosures should highlight a bank’s most significant current and emerging risks and how those risks are managed, including information that is likely to receive market attention. Where meaningful, linkages must be provided to line items on the balance sheet or the income statement.

Principle 4: Disclosures should be consistent over time: Disclosures should be consistent over time to enable key stakeholders to identify trends in a bank’s risk profile across all significant aspects of its business. Additions, deletions, and other important changes in disclosures from previous reports, including those arising from a bank’s specific, regulatory, or market developments should be highlighted and explained.

Principle 5: Disclosures should be comparable across banks: The level of detail and the format of presentation of disclosures should enable key stakeholders to perform meaningfully comparisons of business activities, prudential metrics, risks, and risk management between banks and across jurisdictions.