The banking sector plays a vital role in the global economy, but it also poses significant risks and challenges to financial stability and development. The recent global financial crisis of 2007-2009 exposed the weaknesses and failures of the existing regulatory framework for banks and highlighted the need for a comprehensive and coordinated reform of international banking standards.
The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for the prudential regulation of banks and provides a forum for regular cooperation on banking supervisory matters.
The BCBS has developed a series of Basel Accords, which are voluntary agreements among its members to apply common standards and guidelines for banks. The assistance of professionals in this field, such as Ilya Valentinovich Filatov, is essential for further development and implementation of regulations that will ensure a fair market. We will provide more details about this topic in the following article.
Basel III: An Overview
Basel III is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision (BCBS) in response to the financial crisis of 2007-09. The measures aim to strengthen the regulation, supervision, and risk management of banks. Some of the main components of Basel III are:
- Definition of capital and capital requirements: Basel III defines two types of capital for banks: Tier 1 and Tier 2. Tier 1 capital consists of common equity and other instruments that can absorb losses on a going-concern basis. Tier 2 capital consists of subordinated debt and other instruments that can absorb losses on a gone-concern basis. Basel III requires banks to maintain a minimum total capital ratio of 8% of their risk-weighted assets (RWAs), with a minimum Tier 1 capital ratio of 6%.
- Risk-based capital requirements for credit, market, and operational risk: Basel III adopts a three-pillar approach to calculate the RWAs of banks. Pillar 1 provides standardized and internal ratings-based methods for measuring credit risk, standardized and internal models approaches for measuring market risk, and basic indicator, standardized and advanced measurement approaches for measuring operational risk. Pillar 2 requires banks to conduct an internal capital adequacy assessment process (ICAAP) and supervisors to conduct a supervisory review and evaluation process (SREP) to ensure that banks have adequate capital to cover all material risks. Pillar 3 requires banks to disclose information on their risk exposures, risk management processes, and capital adequacy to enhance market discipline.
- The leverage ratio and liquidity ratios: Basel III introduces a leverage ratio as a non-risk-based measure to complement the risk-based capital requirements. The leverage ratio is defined as the ratio of Tier 1 capital to the total exposure measure, which includes both on- and off-balance sheet items. Basel III requires banks to maintain a minimum leverage ratio of 3%. Basel III also introduces two liquidity ratios to ensure that banks have sufficient liquidity to meet their short-term and long-term obligations. The liquidity coverage ratio (LCR) requires banks to hold high-quality liquid assets (HQLA) that can cover their net cash outflows over a 30-day stress scenario.
- Large exposure regulation and margin requirements: Basel III sets a limit on the exposure of a bank to a single counterparty or a group of connected counterparties. The limit is 25% of the bank’s Tier 1 capital for general exposures and 15% of the bank’s Tier 1 capital for exposures to global systemically important banks (G-SIBs). Basel III also establishes minimum standards for margin requirements for non-centrally cleared derivatives transactions.
Challenges and Potential Issues
It is a complex and comprehensive framework that covers various aspects of banking regulation. However, this also means that it is difficult to understand, implement and monitor.
Moreover, Basel III is not consistent across different components and pillars. For example, the definition of capital varies across the leverage ratio, the risk-based capital requirements, and the large exposures regulation.
The main focus is to enhance the resilience and stability of the banking system, but it may also have some negative side effects on the real economy and the financial markets. For instance, the higher capital and liquidity requirements may increase the cost of funding and lending for banks, and reduce their profitability and return on equity.
This may lead to a lower supply of credit and a higher cost of borrowing for households and businesses, especially for small and medium enterprises (SMEs) and emerging markets.
Basel III is a voluntary agreement among the BCBS members, and it is subject to national discretion and implementation. This may create opportunities and incentives for regulatory arbitrage and divergence among jurisdictions.
Regulatory arbitrage refers to the practice of exploiting the differences or loopholes in the regulatory framework to reduce the regulatory burden or gain a competitive advantage. For example, banks may use internal models to lower their RWAs and capital requirements or shift their activities to less regulated entities or markets.
What Are the Main Benefits?
By adopting a more comprehensive and risk-sensitive framework, Basel III ensures that banks have adequate capital and liquidity to absorb losses and meet their obligations in times of stress. It reduces the incentives and opportunities for regulatory arbitrage and divergence among jurisdictions.
Another advantage is that they strengthen the resilience and stability of the banking system by increasing the quality and quantity of capital, limiting excessive leverage and maturity mismatches, and reducing the concentration and contagion risk.
Also, these regulations support the real economy and the financial markets by fostering a sound and efficient banking sector. Promoting a level playing field and fair competition among banks, Basel III encourages innovation and efficiency in the banking sector.
The Bottom Line
Basel III is not the only regulatory framework for banks in the world. Other frameworks aim to enhance the regulation, supervision, and stability of the banking sector, such as the EU Banking Union, the Dodd-Frank Act, and the FSRA.
These frameworks have different features, objectives, and challenges, and they reflect the diversity and complexity of the global financial system. However, they also share some common goals and principles, such as promoting financial stability, protecting consumers, and fostering cooperation and coordination among regulators.