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Basel III
BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11.[1] This, the third of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. For instance, the change in the calculation of loan risk in Basel II which some consider a causal factor in the credit bubble prior to the 2007-8 collapse: in Basel II one of the principal factors of financial risk management was out-sourced to companies that were not subject to supervision: credit rating agencies. Ratings of creditworthiness and of bonds, financial bundles and various other financial instruments were conducted without supervision by official agencies, leading to AAA ratings on mortgage-backed securities, credit default swaps and other instruments that proved in practice to be extremely bad credit risks. In Basel III a more formal scenario analysis is applied (three official scenarios from regulators, with ratings agencies and firms urged to apply more extreme ones). The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.[2][3] Outside the banking industry itself, criticism was muted. Bank directors would be required to know market liquidity conditions for major asset holdings, to strengthen accountability for any major losses.

Summary of proposed changes

First, the quality, consistency, and transparency of the capital base will be raised. o Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings o Tier 2 capital instruments will be harmonised o Tier 3 capital will be eliminated.[5] Second, the risk coverage of the capital framework will be strengthened. o Promote more integrated management of market and counterparty credit risk o Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit rating o Strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repo and securities financing transactions o Raise the capital buffers backing these exposures o Reduce procyclicality and o Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses)

Page |2 Provide incentives to strengthen the risk management of counterparty credit exposures o Raise counterparty credit risk management standards by including wrong-way risk Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework. o The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sector Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures. Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting countercyclical buffers"). o The Committee is introducing a series of measures to address procyclicality: Dampen any excess cyclicality of the minimum capital requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and o Achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth. Requirement to use long term data horizons to estimate probabilities of default, downturn loss-given-default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. Banks must conduct stress tests that include widening credit spreads in recessionary scenarios. o Promoting stronger provisioning practices (forward looking provisioning): Advocating a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).[6] Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued a statement saying that regulators will allow banks to dip below their required liquidity levels, the liquidity coverage ratio, during periods of stress.[7]) The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.
o

As on Sept 2010, Proposed Basel III norms ask for ratios as: 7-9.5%(4.5% +2.5%(conservation buffer) + 0-2.5%(seasonal buffer)) for Common equity and 8.5-11% for tier 1 cap and 10.5 to 13 for total capital (Proposed Basel III Guidelines: A Credit Positive for Indian Banks)'

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Macroeconomic Impact of Basel III

An OECD study[2] released on 17 February 2011, estimates that the medium-term impact of Basel III implementation on GDP growth is in the range of 0.05 to 0.15 percentage point per year. Economic output is mainly affected by an increase in bank lending spreads as banks pass a rise in bank funding costs, due to higher capital requirements, to their customers. To meet the capital requirements effective in 2015 (4.5% for the common equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increase their lending spreads on average by about 15 basis points. The capital requirements effective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio) could increase bank lending spreads by about 50 basis points. The estimated effects on GDP growth assume no active response from monetary policy. To the extent that monetary policy will no longer be constrained by the zero lower bound, the Basel III impact on economic output could be offset by a reduction (or delayed increase) in monetary policy rates by about 30 to 80 basis points.[8] Basel III is an opportunity as well as a challenge for banks. It can provide a solid foundation for the next developments in the banking sector, and it can ensure that past excesses are avoided. Basel III is changing the way that banks address the management of risk and finance. The new regime seeks much greater integration of the finance and risk management functions. This will probably drive the convergence of the responsibilities of CFOs and CROs in delivering the strategic objectives of the business. However, the adoption of a more rigorous regulatory stance might be hampered by a reliance on multiple data silos and by a separation of powers between those who are responsible for finance and those who manage risk. The new emphasis on risk management that is inherent in Basel III requires the introduction or evolution of a risk management framework that is as robust as the existing finance management infrastructures. As well as being a regulatory regime, Basel III in many ways provides a framework for true enterprise risk management, which involves covering all risks to the business.[9]

Key dates
Capital Requirements
Date 2013 2015 2016 2019 Milestone: Capital Requirement Minimum capital requirements: Start of the gradual phasing-in of the higher minimum capital requirements. Minimum capital requirements: Higher minimum capital requirements are fully implemented. Conservation buffer: Start of the gradual phasing-in of the conservation buffer. Conservation buffer: The conservation buffer is fully implemented.

Leverage Ratio
Date Milestone: Leverage Ratio 2011 Supervisory monitoring: Developing templates to track the leverage ratio and the

Page |4 underlying components. Parallel run I: The leverage ratio and its components will be tracked by supervisors but not disclosed and not mandatory. Parallel run II: The leverage ratio and its components will be tracked and disclosed but not mandatory. Final adjustments: Based on the results of the parallel run period, any final adjustments to the leverage ratio. Mandatory requirement: The leverage ratio will become a mandatory part of Basel III requirements.

2013 2015 2017 2018

Liquidity Requirements
Milestone: Liquidity Requirements Observation period: Developing templates and supervisory monitoring of the liquidity 2011 ratios. 2015 Introduction of the LCR: Introduction of the Liquidity Coverage Ratio (LCR). 2018 Introduction of the NSFR: Introduction of the Net Stable Funding Ratio (NSFR). Date

Studies on Basel III

In addition to articles used for references (see References), this section lists links to recent highquality publicly-available studies on Basel III. This section may be updated frequently as Basel III is currently under development. Date Source Feb BNP Paribas 2012 Fortis Dec 2011 Jun 2011 Feb 2011 Jan 2011 May 2010 May 2010 Article Title / Link Comments Basel III for dummies "All you need to know about Basel III in 10 Video minutes." OECD analysis on the failure of bank regulation OECD: Economics Systemically and markets to discipline systemically important Department Important Banks banks. BNP Paribas: Economic Basel III: no Achilles' BNP Paribas' Economic Research Department Research spear study on Basel III. Department OECD: Economics Macroeconomic OECD analysis on the macroeconomic impact Department Impact of Basel III of Basel III. Basel III New Capital Basel III standards, key elements of new Moody's Analytics and Liquidity regulations, framework, and key Standards FAQs implementation dates. OECD Journal: Thinking Beyond Financial Market OECD study on Basel I, Basel II and III. Basel III Trends Bloomberg FDICs Bair Says Bair said regulators around the world need to BusinessWeek Europe Should Make work together on the next round of capital

Page |5 standards for banks ... the next round of international standards, known as Basel III, which Bair said must meet very aggressive goals. Finance ministers from the G20 group of FACTBOX-G20 industrial and emerging countries meet in progress on financial Busan, Korea, on June 45 to review pledges regulation made in 2009 to strengthen regulation and learn lessons from the financial crisis. "The most important bit of reform is the The banks battle back international set of rules known as Basel 3, A behind-the-scenes which will govern the capital and liquidity brawl over new capital buffers banks carry. It is here that the most and liquidity rules vicious and least public skirmish between banks and their regulators is taking place." Banks Hold More Capital

May Reuters 2010

May The Economist 2010

TOWARDS BASEL III

This is an attempt to trace the progress of the Basel Accord, and visualize Basel III framework. Stage 1 (Pre-1988): Though bank failures were not unheard of, it was the failure of Bank Herstatt in Germany, in 1974, which received international attention, on account of its regulatory implications. The bank became insolvent on account of its large and risky foreign exchange business, and its losses amounted to DM 470 million. The tremors felt in the International structure as a result of this catastrophe led to the drawing up of the Basel I Accord by the Basel Committee on Banking Supervision (BCBS) in 1988. Stage 2 (1988- 2004): The Basel I Accord was built on the sole pillar of Capital adequacy, to insulate the banking structure from losses incurred. Though the recommendation of 8% capital adequacy (figure arrived at post intense debate and discussion), were not regulatory in nature, the recommendations were implemented by most Central Banks.

Page |6 However, despite the implementation of the Basel I framework, a series of incidents continued to send tremors throughout the financial world. 1. Bank of Credit and Commerce International (1991): one of the worlds worst financial scandals and what was called a $20-billion-plus heist. The Bank of England closed down BCCI after it was found to be involved in money laundering, bribery, support of terrorism, arms trafficking, the sale of nuclear technologies, the commission and facilitation of tax evasion, smuggling, illegal immigration, and the illicit purchases of banks and real estate. The bank was found to have at least $13 billion unaccounted for. 2. Metallgesellschaft a subsidiary of Deutsche Bank (1993): losses of over $1.4 billion due to model error resulting from incorrect assumptions about futures prices in energy markets. 3. Bankers Trust (1993): losses of over $400 million due to selling inappropriate products to clients; Stage 3 (2004 the Present) Following the failure of the one size fits all approach and the lessons drawn from financial tragedies, the BCBS released the Basel II framework in 2004. The Basel II framework rested on the 3 pillars of Capital Adequacy, Supervisory Review and Market Discipline. Operational Risk was defined as a new risk category requiring specific attention. While the Central Banks across the world debated over the proposed framework, the moral degradation across the international financial world continued. 1. Kidder Peabody (1994): losses of over $350 million due to alleged concealment of trading losses to protect bonuses. 2. Barings Bank (1995) Collapsed in 1995 after one of the banks employees, Nick Leeson, lost $1.4 billion in speculation primarily on futures contracts. 3. Daiwa Bank (1995): losses of over $1.1 billion due primarily to fraudulent trading over 11 years by an employee to cover trading losses. 4. Republic Securities (1999): losses of over $600 million and loss of trading license due to its support of fraudulent trading by a broker for which it provided false documentation to the brokers clients and regulators. The brokers fraudulent activities were known to the

Page |7 management of the firms futures division and persisted for several years and hence should have been picked up by management and auditors. 5. Enron (2001): achieved infamy when it was revealed that its reported financial condition was sustained mostly by institutionalized, systematic, and creatively planned accounting fraud. Enron has since become a popular symbol of willful corporate fraud and corruption. 6. Allied Irish Bank (2002): losses of $691.2 million on account of an apparent currency fraud at its Baltimore based subsidiary, All first, perpetrated by a trader named John Rusnak. It was one of the biggest rogue trader scandals since Nick Leeson brought down Barings bank in 1995. 7. China Aviation Oil (2004): Losses of over $500 million due to fraudulent trading by an employee to cover energy trading losses Stage 4 (The Present 11- Basel III) Increasingly it is becoming evident that Capital Adequacy norms alone are insufficient. In fact capital adequacy is a tool being employed at the lower end of the value chain, rendered toothless if not supported by strong supervisory norms and market disclosure requirements.

BASEL III refers to a new update to the Basel Accords that is under development. While the Bank for International Settlements (BIS) does not currently specify this work as "Basel III", the term appeared in the literature as early as 20051 and is now in common usage2 anticipating this next revision to the Basel Accords. The draft Basel III regulations include:
1 2

Tighter definitions of Tier 1 capital, The introduction of a leverage ratio,

From Basel II to Basel III By: Schulte-Herbrggen, Walter; Becker, Gernot. Risk, Jan2005, Vol. 18 Issue 1, p58. The Basel III Proposals' Flaws... By: Cassidy, Gerard S.. American Banker, 5/13/2010, Vol. 175 Issue 74, p8-8, 1/2p, The Lesson of Basel's Bean Counters by George Melloan, The Wall Street Journal, April 24, 2010

Page |8 A framework for counter-cyclical capital buffers, Measures to limit counterparty credit risk, and Short and medium-term quantitative liquidity ratios3.

Professionals and officers with Basel II knowledge and experience will be required to lead the new Basel III projects, and they have started studying the differences from the Basel II framework4.

Overview
Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.[4] In response to the recent financial crisis, the Basel Committee on Banking Supervision (BCBS) set forth to update their guidelines for capital and banking regulations: This consultative document presents the Basel Committee's proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the Basel Committee's reform package is to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy. While Basel 3 has the potential to address some of these issues, the comparability of regulatory ratios would still be blurred by differences between banks' internal rating models and by the availability of various options to assess identical risks. Equally, we do not expect Basel 3 to resolve all of the differences in approach between national regulators. We note that the U.S., for
3 4

http://www.webcitation.org. http://www.basel-iii-association.com

Page |9 example, has been slower than other major countries in its implementation of Basel 2, and we consider that similar variations are likely under Basel 3. We view positively the strong improvement in transparency and the emphasis placed on market discipline in the various elements of the Basel 3 proposals. To date, we believe the disclosure provided by banks regarding regulatory capital measures has frequently been deficient. We are currently reviewing the detail of the Basel 3 consultative documents, and we intend to publish more extensive analysis of them before the comment period ends on April 16, 2010. "At this early stage, we do not expect that Basel 3, once implemented, would likely have a material impact on our bank ratings, which are partly predicated on capitalization being strengthened before governments reduce their support of the banking system," said Mr. Barnes. We will, of course, revisit this conclusion as the Basel 3 proposals move closer to their final form.

On December 19, 2009 the BCBS issued a press release 5 which presented to the public two consultative documents for review and comment: * Strengthening the resilience of the banking sector. * International framework for liquidity risk measurement, standards and monitoring. The BCBS allowed a public comment period (ended April 16, 2010) resulting in 272 responses to their request for comment. Development of the New Basel III Standard Summary of Changes Proposed in Basel III

Development of the New Basel III Standard

5

First, the quality, consistency, and transparency of the capital base will be raised.

Consultative proposals to strengthen the resilience of the banking sector announced by the Basel Committee.

P a g e | 10 Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings.

Tier 2 capital instruments will be harmonized. Tier 3 capital will be eliminated.

The risk coverage of the capital framework will be strengthened. Strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repo and securities financing transaction. Raise the capital buffers backing these exposures. Reduce procyclicality and Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses). Provide incentives to strengthen the risk management of counterparty credit exposures

Key Dates December 19, 2009 April 16, 2010

Milestone BIS published documents for public review/comment End of the public comment period

P a g e | 11 April 23, 2010 June 3-5, 2010 June 2627, 2010 June 30, 2010 October 22-23, 2010 November 11-12, 2010 December 31, 2010 December 31, 2011 December 31, 2012 Meeting of G-20 Finance Ministers and Central Bank Governors, Meeting of Finance Ministers and Central Bank Governors Busan. G-20 Toronto Summit Comprehensive impact assessment & calibration Meeting of Finance Ministers and Central Bank Governors, G-20 Seoul Summit fully calibrated set of standards will be developed all major G-20 financial centers commit to have adopted the Basel III Capital Framework by 2011. Target for implementation of Basel III

Conclusion:
Implementation of Basel III has been described as a long journey rather than a destination by itself. Undoubtedly, it would require commitment of substantial capital and human resources on the part of both banks and the supervisors. RBI has decided to follow a consultative process while implementing Basel III norms and move in a gradual, sequential and co-ordinate manner. For this purpose, dialogue has already been initiated with the stakeholders. As envisaged by the Basel Committee, all the professionals will make a positive contribution in this respect to make Indian banking system stronger.

Bibliography
http://www.webcitation.org. http://www.basel-iii-association.com