In December 2010, the Basel Committee on Banking Supervision published its reforms to capital and liquidity rules to address the lessons of the financial crisis that began in 2007. Capital and liquidity standards are set out in two separate policy documents (BCBS188 & BSBS189), which together form the Basel III framework.

Basel III strengthens the Basel II framework rather than replaces it. Whereas Basel II focused on the asset side of the balance sheet, Basel III mostly addresses the liabilities side i.e. capital and liquidity.

Capital Requirements

Regulatory capital under Basel III is defined as the sum of the following elements:

• Tier 1 Capital intended to ensure each bank remains a “going-concern”. This includes a new capital standard, Common Equity Tier 1 (CET1) capital; predominantly share capital, share premium, retained earnings and regulatory adjustments.
• Tier 2 Capital re-categorised as a “gone-concern” reserve to protect depositors in the event of insolvency.

As well as changing eligibility criteria for Tier 1 and Tier 2 capital, Tier 3 capital that existed under Basel II to cover market risks is abolished. Regulatory adjustments (deductions) are mostly applied to CET1 capital. Innovative hybrid capital instruments with step-up clauses will be phased out.

In addition to minimum capital requirements, two capital buffers are added:

• Conservation Buffer intended to enable each bank to maintain capital levels above the minimum requirements throughout a significant sector down-turn.
• Countercyclical Buffer to be implemented by the national supervisor (the FSA in the UK) when there is excessive credit growth in the economy.

Both buffers must be raised through common equity (CET1). The buffers are not strictly additional minimum capital requirements and may be drawn down during periods of stress. However, the rules are designed to restrict the bank’s ability to distribute its earnings until the buffers are rebuilt.

The diagram below summarises capital requirements and buffers:

Counterparty Credit Risk

In addition to Basel II revisions concerning market risk capital charges (effective from end-2010), Basel III includes a number of technical measures to increase capital requirements for trading counterparty risk. These are intended to address perceived deficiencies in Basel II during periods of acute market volatility and include:

• The use of stressed inputs when calculating counterparty credit risk using the internal model method.
• A new capital charge, Credit Valuation Adjustment (CVA), to cover the risk of mark-to-market losses on the expected counterparty risk to OTC derivatives. This is additional to the default risk capital charge.
• Additional standards for collateral management and initial margining. Banks with large and illiquid exposures to counterparties will have to apply longer margining periods to determine capital requirements.
• Lower risk weightings to central counterparties (CCPs) to incentivise banks to move exposures to CCPs.
• Other measures to address counterparty credit risk, including identification and treatment of wrong-way risk.

Capital Leverage Ratio

The newly introduced leverage ratio is intended to serve as a simple non-risk based metric to supplement risk-based requirements. The basis of the calculation is the average of the monthly leverage ratio over the quarter:

The exposure measure should generally follow accounting treatment:

• On-balance sheet items, net of specific provisions and valuation adjustments.
• Collateral, guarantees or credit mitigation purchased should not reduce on-balance sheet exposures.
• Netting of loans and deposits is not allowed.
• Securities funding transactions and derivative exposures should be included by applying accounting treatment and Basel II netting rules. Derivative exposures should include an add-on for potential future exposure using CEM.
• Off-balance sheet (OBS) items are also included with a CCF of 100% unless unconditionally cancellable, in which case a CCF of 10% applies.

This measure will initially be a Pillar 2 supervisory monitoring tool, with Pillar 3 disclosure and eventual migration to Pillar 1 taking place as outlined in the timetable below. A minimum Tier 1 leverage ratio of 3% is proposed for the parallel run period.

Liquidity Coverage Ratio

This is one of two liquidity ratios introduced in Basel III. It is designed to ensure that a bank maintains an adequate level of unencumbered assets that can meet its liquidity needs for a 30 day period under a severe stress scenario specified by the regulator.

High-quality liquid assets are those that can easily and immediately be converted into cash with minimal loss of value. There are two categories of assets that can be included in the stock – Level 1 and Level 2, as shown below. Note that Level 2 assets may comprise no more than 40% of the overall stock after the minimum 15% haircut has been applied.

The net cash flow over the 30-day stress period is calculated by multiplying outstanding balances by the rates they are expected to run off, as shown in the tables below:

Total cash inflows, up to a ceiling of 75% of total cash outflows, are subtracted from cash outflows to arrive at the net figure.

Note that the cap on total cash inflows is intended to prevent banks relying solely on anticipated inflows when under stress. In effect, the minimum amount of stock of liquid assets that must be held is equal to 25% of the total cash outflows over the 30-day stress period.

Net Stable Funding Ratio

The net stable funding ratio is the second Basel III liquidity metric. It is designed to ensure that a bank holds an amount of long-term funding (sources) at least equal to its long-term assets (uses, such as lending):

The tables below provide a summary of the definition of available sources of funding (sources) and required stable funding (uses), with the weightings used in the calculation shown alongside:

Basel III Timetable

EU Implementation of Basel III

Although the Basel Committee formulates international supervisory standards and guidelines it has no legal authority. Within the European Union, the passing of Basel banking standards into legislation has hitherto been achieved through the means of directives, which in turn were implemented through national measures (see EU Implementation of Basel II).

In order to “maximise harmonisation”, the EU has chosen to implement the majority of Basel III rules through direct regulation, without the need to be written into national law. This is designed to prevent EU member states ‘gold-plating’ or adding to EU legislation.

Confusingly, Basel III is implemented through what is known as CRD IV, even though rules on the quality and quantity of capital, counterparty risk, liquidity and leverage are in fact contained within the CRD IV Regulation). However, some rules, most notably those concerning the capital conservation and counter-cyclical buffers, are implemented by the CRD IV Directive.