“Fed Guy” Joseph Wang – Monetary System Deep Dive

Basel III Deep Dive

In the financial media, you frequently hear pundits refer to the Basel III Accords when discussing the banking system. But exactly is Basel III?

Basel III refers to a new set of international regulatory measures that were drafted in response to the global financial crisis in 2007-09. While not legally binding, the measures have been agreed upon by a majority of internationally active banks and they aim to make banks more resilient to future economic crises through strengthened regulation, supervision, and risk management of the international banks.

The Basel III Accords were drafted by the Basel Committee on Banking Supervision (BCBS) with measures that include increasing capital requirements, leverage ratios, and liquidity requirements.

History

As the term suggests, Basel III is the third evolution of international banking measures constructed by the BCBS.

The first set of measures dates back to 1974 when the G10 countries established a predecessor to the BCBS called the Committee on Banking Regulations and Supervisory Practices. This committee’s primary focus was on increasing supervisory coverage of banks to boost financial stability worldwide.

Unfortunately, the committee was only able to shorten the name by two words.

In 1988, it would go on to establish the Basel Capital Accord that instituted a minimum capital requirement to risk-weighted assets ratio of 8%. The 1988 Accord was amended a few times before Basel II was introduced in June 2004.

Basel II was released with “three pillars” that focused on minimum capital requirements, supervision and internal assessment processes, and using disclosures to strengthen market discipline and sounds banking practices.

As we have learned from the history books, these measures were not enough to prevent banks from over-extending their lending practices and the entire world financial system came crashing down in 2007-09.

This set the stage for Basel III that was released in December of 2010 which added on more regulatory framework in hopes to prevent another future collapse.

Capital Requirements

Capital requirements were introduced by the BCBS in earlier accords to make sure that banks had enough capital to honor withdrawals if they took losses from their risk asset holdings.

One of the measures of Basel III was an increase in the minimum capital requirements for banks to hold against their risk assets.

After full implementation of the measure in 2019, compliant banks would need to hold minimum common equity to risk-weighted assets of 4.5% along with a capital conversion buffer of 2.5% that would restrict shareholder distributions if the ratio were to fall into the buffer zone.

Leverage Ratio

Alongside increased capital requirements, a new addition to the accords was the introduction of a non-risk-based leverage ratio that would act as a backstop to the minimum capital requirement. The goal of this ratio is to prevent an excessive buildup of leverage in the system.

For internationally active banks, this meant that Tier 1 capital of the bank must be at least 3% of the bank’s balance sheet exposure that includes derivatives, repos, and other securities that are held in the shadows.

Liquidity Requirements

The Basel III measures also aimed to supervise bank liquidity standards

For times of economic stress, participating banks are required to hold sufficient liquid assets to sustain 30 days of operations. This is regulated through the Liquidity Coverage Ratio. This ratio was initially set at 60% in 2015 and was gradually increased by 10% each year until it reached 100% in 2019.

An additional ratio that was implemented is referred to as the Net Stable Funding Ratio. This measure requires banks to hold stable funds above the minimum amount for an extended period after times of economic stress. The goal is to encourage banks to maintain stable funding by matching the duration of their assets and liabilities. This ratio was implemented in 2018 and pegged at 100%.

Effects of Basel III

Reviews for the most recent Basel accords have been mixed. Some proponents argue that the updated measures are improvements to keeping the banking system in check, while others argue that the new measures create a moral hazard and stunt economic growth.

Because these measures require banks to hold more capital in reserves, banks might be negatively encouraged to lower their lending standards to receive higher margins on the smaller amount of loans issued to borrowers.

Banks normally stimulate economic growth by lending to businesses and entrepreneurs in the economy who produce goods and services that create economic value. By having to hold more capital in reserve, they are not able to create as many loans that go on to create economic value.

These new accords are still relatively young so it may be too early to judge their effectiveness. But hopefully, over time, the Basel III increased measures will result in a more resilient international banking system as they are intended to.

The possibility of a looming financial crisis would be the perfect opportunity to test this newfound resiliency.