As is widely known, Basel III is a response by regulators to perceived weaknesses in the existing Basel II framework. Whilst Basel III has a wide remit - including extensive, new requirements for securitisations and trading - this note focuses on the main capital, leverage and liquidity requirements.
Basic capital requirements - Tier 1, 2 and 3
The basic 8 per cent minimum ratio of capital to RWA remains under Basel III. However, whilst Tier 1 capital under Basel II could be constructed of both common equity (e.g. ordinary shares in England) and other capital instruments, common equity performed best in absorbing losses throughout the crisis. The Basel Committee has focused on this and notes that the minimum requirement currently is that banks issue common equity equal to 2 per cent of RWA. Basel III proposes to increase this requirement to 4.5 per cent of RWA, to be phased in by 1 January 2015 at the latest.
Basel III also introduces stricter regulatory deductions (e.g. for minority interests) for calculating Tier 1 capital and tighter requirements for capital instruments which are not common equity to form part of Tier 1 capital. On the second point, the Basel Committee acknowledges that certain innovative features have been introduced to Tier 1 capital over the years (e.g. margin step-ups) to lower the cost of raising Tier 1 capital but has stated that those features are to be phased out.
Tier 2 capital is also to be simplified and Tier 3 capital is to be phased out.
In addition to strengthening Tier 1 capital, two capital buffers will be added - a capital conservation buffer equal to 2.5 per cent of RWA and a countercyclical buffer of an additional 0 per cent to 2.5 per cent of RWA. Both buffers must be raised through common equity.
The broad basis for this proposal comes from the observation that some institutions with heavy losses and depleted capital from the crisis still made distributions to shareholders. The Basel Committee argues that this should not occur and that banks who suffer losses should rebuild their capital by retaining earnings and raising new capital. The guiding principle is to shift the risk as much as possible from depositors to shareholders and employees of banks.
As such, the buffers are not additional, minimum capital requirements. Instead, if an institution does not have the required capital buffers, Basel III will restrict the institution’s ability to distribute earnings.
Of the two types of buffer, the capital conservation buffer is intended to be large enough to enable banks to maintain capital levels above the minimum requirement throughout a significant sector-wide downturn. The countercyclical buffer is an additional requirement which will be implemented by national supervisors when there is excess credit growth in their economy, with the intention of dampening such credit growth.
The capital conservation buffer should be phased in by 1 January 2019 at the latest. The countercyclical buffer is still subject to consultation but national supervisors are expected to have more discretion in implementation.
In addition to increased risk-based capital requirements, Basel III introduces for the first time a leverage ratio. The intention is to constrain the build up of leverage in the banking sector with a simple metric. The current proposal by the Basel Committee is to test a leverage ratio set at 3 per cent of Tier 1 capital as part of the Pillar 2 supervisory review with a view to migrating this to a Pillar 1 requirement by 1 January 2018.
During the crisis, a number of banks suffered from significant liquidity problems and required unprecedented state support to continue operations. Part of this risk is to be addressed by improved bank policies and oversight by board and senior management. It is also proposed to introduce two standards for the liquidity of bank assets.
The first standard is the Liquidity Coverage Ratio (LCR) to ensure that banks have sufficient liquidity to deal with severe market shocks. This requires a bank to hold sufficient high quality liquid assets that can be converted into cash to meet its cash outflows for a 30 day period in a high stress scenario specified by supervisors. The liquid assets are intended to have a low credit and market risk, be short duration and be issued in an active and large market. The stress scenario contemplated is based on a market-wide shock which leads to, amongst other things, a three notch downgrade for the bank; a run-off of a certain proportion of its retail deposits; and a loss of the bank’s access to unsecured wholesale funding.
The second standard is the Net Stable Funding Ratio (NSFR) which is intended to promote more medium and long-term funding of banks’ activities. In summary, it establishes a minimum amount of stable funding based on the liquidity characteristics of an institution’s assets and activities over a one year horizon. Stable funding in this context means capital, preferred stock and debt with maturities of more than one year and that portion of deposits with maturities of shorter than a year that would be expected to stay with the institution in a stress scenario.