Basel III Design and Implementation

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Basel 3 Design and implementation

Basel 3 is an international regulatory mechanism adopted after the financial crisis in 2009. The mechanism entails regulating commercial banks and ensuring that they avoid taking excessive risks that may potentially harm the economy¹. Basel 3 builds upon the prior Basel 2 and Basel 1. Basel 3 is strategically designed to increase regulation in the banking sector and ensure that the banks maintain proper leverage ratios and reserve requirements. Basel 3 was initially meant to help in helping 28 published countries respond to the global economic crisis. However, recent economic trends worldwide have led to an increase in the adoption of the Basel 3 accord. In this paper, we are going to aces the implementation and design of Basel 3 and its potential benefits to the economy.

Basel III is a global regulatory agreement that has launched a set of reforms aimed at enhancing banking regulation, supervision, and risk management¹. The accord is an improvement to the Basel 2 framework. It is anchored on enhancing the banking regulatory framework. Since commercial banks were the major contributor to the 2009 financial crisis, the framework sets in creating regulations that will ensure that the actions of commercial banks are monitored and restricted from undertaking too great risks at the expense of the economy.

Basel Committee

Basel framework was created in 1974. This framework was initially designed to the immense disruptions in the financial market. The initial setup consisted of 10 countries famous as the G10. The accord stimulated financial stability by regulating the actions of commercial banks and acting as a supervisory agent. In 2009, Basel 3 was formulated and the jurisdiction was also expanded to 28 countries. These countries are Canada, Brazil, France, Australia, Argentina, China, India, Saudi Arabia, Belgium, the Netherlands, Russia, Hong Kong, Japan, Italy, Mexico, Korea, ²Spain, Sweden Singapore, Turkey, Switzerland, South Africa, Germany, Indonesia, the United Kingdom, the United States, and Luxembourg. Recent economic trends have seen a rise in the members to 45.

The Basel Committee on Banking Supervision (BCBS) is tasked with the mandate of developing the governing principles³. The Basel committee reports to the Group of Governors and Head of Supervision (GHOS). The secretariat of the committee is located in Basel, Switzerland at the Bank of International Standards (BIS).

Basel 3 response to the 2007- 2009 Economic Crisis.

With the looming financial crisis in 2007, there was an apparent need to strengthen the prior Basel 2 framework. The banking sector had entered into a risky situation having too much leverage and a serious liquidity crisis¹. The crisis had been propagated by poor risk management, improper incentives, and poor governance⁴. A combination of these factors contributed to excessive growth of credit which was mispriced and also increased the liquidity risk.

The committee comprising of 28 members¹⁵ states came up together to formulate various policies to mitigate the looming economic crisis. These policies can be subdivided into three distinct principles;

1. Minimum Capital Requirement

After having experienced the financial crisis Basel 3 committee increased the commercial banks’ minimum capital requirement from 2% in the prior Basel 2 framework to 4.5% of common equity as a percentage of the risk-weighted assets. The minimum capital was brought up to 7% by an additional 2.5% buffer capital. The buffer capital was designed to be utilized in case of serious financial stress¹.

In 2015, the Tier 1 capital allowance increased dramatically from 4% in Basel 2 to 6% in Basel 3. Tier 1 is concerned with cushioning banks as well as maintaining operational stability. Tier 2, on the other hand, applies to supplemental capital that can be used in times of severe financial crisis⁴. The minimum total capital allowance under Basel 3 is 12.9 percent⁴. Tier 1 contributes the most capital (10.5 percent of total risk-weighted assets), while Tier 2 contributes the least capital (2 percent of total risk-weighted assets).

2. Leverage ratio

This is a measure of the ability of an entity to meet its short-term obligations. The Basel 3 committee proposed a less risky leverage ratio policy to⁵ supplement the risk-based minimum capital requirement technique. These measures were meant to mitigate the risk of excessive borrowing and ensured banks had sufficient liquidity in times of financial stress. The leverage ratio was determined by dividing the Tier 1 capital by the total consolidated bank assets fewer intangible assets¹. This ratio was capped at 3%. To ensure compliance the Fed fixed the ratio at 5% for insured bank holdings and 6% for SIFI (Systematically important Financial institutions)

3. Liquidity requirement

Liquidity is the ability of an entity to convert its assets into cash or near-cash equivalents. The Basel 2 committee came up with 2 distinct financial ratios;

• Net stable funding ratio, and

• Liquidity coverage ratio

Net Stable Funding Ratio –

For one year, the NSFR requires banks to maintain stable and consistent funds above the required standard of minimum stable funding. The NSFR is designed to deal with liquidity discrepancies and will be launched in 2018.

Liquidity Coverage Ratio –

The liquidity coverage ratio requires banks to hold highly liquid assets that can withstand 30-day period stress. This policy was formulated in 2015³ and is expected to increase gradually by 10 % until the year 2019when it is designed to take full effect.

Countercyclical measures

The Basel 3 committee came up with a set of measures through which banks can endure cyclical changes in their balance sheets³. Banks are required to set aside additional capital during times of capital expansion and relaxation of the requirements during the contraction phase of the economy. The new guideline also saw an introduction of the bucketing method that entails grouping companies based on size, importance, and complexity to the overall economy. After grouping, larger banks were characterized as riskier³ and thereby subjected to higher capital requirements as compared to smaller banks.

Impact of Basel 3

As a result of the Basel 3 proposals, banks will try to hold more capital to meet the set 7% requirement. As a result, they will reduce the number of loans issued and subsequently reduce their profits.

There could increase the cost of lending as banks pass the extra cost imposed by the Fed to the final borrower.

To fulfill the asset-liability requirement, banks may opt to reduce the number of long-term assets and prefer to hold more short-term liquid assets subsequently affecting the bond market. The banks may also minimize their operations especially those that contribute to liquidity risk.

In conclusion, the Basel III framework is quite a crucial tool in monitoring the operations of commercial banks. The framework is an improvement of the prior Basel I and Basel II. The framework was adopted in response to the 2007 -2009 financial crisis that was widely caused by indiscriminate lending. The framework comes in to mitigate lending risks and ensuring banks have sufficient liquidity and leverage ratios. The framework also offers an oversight role over commercial banks. Recent economic trends have seen a massive increase in the number of member states and also an immense adoption worldwide as a tool for regulating actions of commercial banks and potentially avoid an economic crisis as that experienced in 2007-2009.

References

Cosimano T, and Hakura D, ‘Bank Behavior In Response To Basel III: A Cross-Country Analysis’ [2011] SSRN Electronic Journal

Li B, ‘The Impact Of The Basel III Liquidity Coverage Ratio On Macroeconomic Stability: An Agent-Based Approach’ [2017] SSRN Electronic Journal

Occhino F, ‘Are The New Basel III Capital Buffers Countercyclical? Exploring The Option Of A Rule-Based Countercyclical Buffer’ [2018] Economic Commentary (Federal Reserve Bank of Cleveland)

Ojo M, ‘Financial Stability, New Macro-Prudential Arrangements And Shadow Banking: Regulatory Arbitrage And Stringent Basel III Regulations’ [2011] SSRN Electronic Journal

Yan M, Hall M, and Turner P, ‘A Cost-Benefit Analysis Of Basel III: Some Evidence From The UK’ (2012) 25 International Review of Financial Analysis