Basel III

Basel III is a comprehensive set of reform measures, developed by the Basel

Committee on Banking Supervision, to strengthen the regulation, supervision and risk of the
banking sector. The Basel Committee is the primary global standard-setter for the prudential
regulation of banks and provides a forum for cooperation on banking supervisory matters. Its
mandate is to strengthen the regulation, supervision and practices of banks worldwide with the
purpose of enhancing financial stability.

It is a set of precautionary measures imposed on banks and are made to protect the
economy from financial crises similar to that of recent years. Principally they aim to ensure
banks accept a level of responsibility for the financial economy they operate within and to act as
a safeguard against further collapse.
Essentially, Basel III and related measures by national and supranational regulators will
force the banks to maintain a much bigger capital base in effect, a foundation stone of solid
assets designed to withstand sudden market disruption. In general Basel III will force banks to
become smaller relative to the size of their national economies. Lower levels of leverage the
ratio of capital to assets will become obligatory. And they must have greater stores of spare
cash on hand to tide them over temporary difficulties.
In the Philippines, on 15 January 2013, the Bangko Sentral ng Pilipinas (BSP) released
Circular No. 781 which provides the implementing guidelines on the revised risk-based capital
adequacy framework particularly on the minimum capital and disclosure requirements. The new
framework which took effect in 2014 is applicable to all universal and commercial banks (U/KBs)
and their subsidiary banks and quasi-banks. This framework allowed a reasonable transition
period for banks to comply with the new minimum requirements. While the international rules
allow staggered implementation, the BSP adopted the capital reforms in full, in recognition of
the strong capital position of the banking industry.
The BSP implements new minimum capital ratios of 6.0 percent Common Equity Tier 1
(CET1) ratio, 7.5 percent Tier 1 ratio and 10.0 percent Total Capital Adequacy Ratio (CAR). A
capital conservation buffer (CCB) of 2.5 percent, comprised of CET1 capital was also
prescribed.

In recognition of the distinct structure of foreign bank branches (FBBs) which operate
under the U/KB license, a calibrated Basel III framework was issued under Circular No. 822
dated 13 December 2014. The reform highlighted the role of Permanently Assigned Capital
which is the CET1 equivalent for FBBs. Shortly after, R.A. No. 10641 amending R.A. No. 7721,
was approved to further liberalize the entry of foreign banks. To implement this law, the BSP
issued Circular No. 858 dated 21 November 2014, providing the new capital computation for
FBBs.
In October 2014, Circular No. 856 Basel III Framework for Dealing with Domestic
Systemically

Important

Banks

(DSIBs)

was

issued

to

address

systemic

risk

and

interconnectedness by identifying banks which are deemed systemically important within the
domestic banking industry. Minimum buffers composed of CET1 capital shall be required of
systemically important banks starting January 2017.

Basel III: Strengthening the Global Capital Framework

A. Capital Reform
A New Definition of Capital
Total regulatory capital will consist of the sum of the following elements:
1. Tier 1 Capital (going-concern capital)
a. Common Equity Tier 1
b. Additional Tier 1
2. Tier 2 Capital (gone-concern capital)
For each of the categories above (1a, 1b and 2) there is a single set of criteria that instruments
are required to meet before inclusion in the relevant category.
Capital Conservation Buffer
The Capital Conservation Buffer is designed to ensure that banks build up capital buffers
outside periods of stress which can be drawn down as losses are incurred. A capital

conservation buffer of 2.5%, comprised of Common Equity Tier 1, is established above the
regulatory minimum capital requirement. Outside periods of stress, banks should hold buffers of
capital above the regulatory minimum.
Countercyclical Capital Buffer
The Countercyclical buffer aims to ensure that banking sector capital requirements take
account of the macro-financial environment in which banks operate.
Minimum Capital Standards
Basel III introduced tighter capital requirements in comparison to Basel I and Basel II.
Banks' regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into
Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because
security instruments included in Tier 1 capital have the highest level of subordination. Common
Equity Tier 1 capital includes equity instruments that have discretionary dividends and no
maturity, while additional Tier 1 capital comprises securities that are subordinated to most
subordinated debt, have no maturity, and their dividends can be cancelled at any time. Tier 2
capital consists of unsecured subordinated debt with an original maturity of at least five years.
Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Riskweighted assets represent a bank's assets weighted by coefficients of risk set forth by Basel III.
The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of
certain assets to establish their risk coefficients.
In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed
as a percent of risk-weighted assets. In particular, Basel III increased minimum Common Equity
Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall
regulatory capital was left unchanged at 8%.

B. Liquidity Standard
1. Short-term: Liquidity Coverage Ratio (LCR)
The LCR is a response from Basel Committee to the recent financial crisis. The LCR
proposal requires banks to hold high quality liquid assets in order to survive in emergent stress
scenario.

Stock of high-quality highly-liquid assets

Net cash outflows over a 30-day time period

*Must be no lower than 1; the higher the better

High-quality highly-liquid assets:

o Level 1 assets: Recognized at 100%: cash, sovereign debt of countries weighted at

0%, deposit at central bank. Level 1 assets shall account for at least 60% of
the high-quality highly liquid assets
o Level 2A assets: Recognized at 85% and must not represent more than 40% of the
assets: sovereign debt weighted at 20% (countries rated below AA-), corporate
bonds and covered bonds rated at least AAo Level 2B assets (introduced Jan, 2013): non-financial corporate bonds rated
between BBB- and A+, with a hair cut of 50%; certain unembumbered equities,
with a hair cut of 50%; and certain residential mortgage-backed securities (RMBS),
with a hair cut of 25%.
o The Level 2B assets will not be eligible for more than 15% of the high-quality
highly liquid assets and a total level 2 assets will not be eligible for more than 40%
of the high-quality highly liquid assets
Changes from January 2013 provide:
o To some extent, lesser cost of carry for banks on high-quality highly-liquid assets
but still limited because of the 50% hair cut and 15% limitation
o Improvement for the financing of investment graded companies (BBB and above)
by banks through bonds, which will remain in competition with residential
mortgage-backed securities (RBMS) with lesser hair cut and whose markets is
restored with these new provisions
o Level 1 assets remain at least 60% of the high-quality highly-liquid assets, which
means that concentration risks and cost of carry remain.
Net cash outflows = cash outflows cash inflows
Cash outflows:

o
o
o

100% of any repayment in the next 30 days

3% (on Jan 6, 2013 decreased from 5%) of retail banking deposits
40% (on Jan 6, 2013 decreased from 75%) of deposits from non-financial
corporates and public sector entities
o 100% of deposits from other financial institutions
o Between 0% and 15% of secured funding backed with high quality highly-liquid
assets
o 10% of credit lines to corporates, sovereign and public sector
o 30% (on Jan 6, 2013 decreased from 100%) of liquidity lines (back-up, swing lines)
to corporates, sovereign and public sector
o 100% of credit lines to other regulated financial institutions
o 0% of secured funding from central banks maturing within 30 days (prior to Jan 6,
2013 the figure was 25%)
Cash inflows:
o 50% of loan repayments by non-financial counterparties (it is considered that
banks, even in difficult times, will have no choice than to renew at least 50% of the
maturing loans)
o 100% of loan repayments by financial institutions
o 100% of bonds repayments (whoever the issuers)
Changes from Jan 2013 provide:

o
o

The new computation of net cash outflows will free hundreds of billion euros
of high-quality highly-liquid assets requirements
Theoretically the changes from Jan 2013 are particularly good news for banks with
large corporate activities

The LCR shall be fulfilled at any time, absent a period of stress. The purpose of this ratio
is to offer a mattress of liquidity under such periods. The Basel Committee expressly mentions
that, during a period of financial stress banks may use their high-quality highly-liquid assets as
a mattress, thereby allowing it to fall under 100%. Initially the Committee planned the LCR
should be in force from Jan 1, 2015 but the schedule has changed: The ration should be at least
60% on Jan 1, 2015, 70% on Jan 1, 2016, and exceed 100% from Jan 1, 2019. As of December
31 2010 more than 95% of the banks already had a LCR exceeding 65% and most banks with
major activities in corporate banking was ranging between 60% to 80%.
2. Long-term: Net Stable Funding Ratio (NSFR)
Objectives:
1. To promote more medium and long-term funding activities of banking organizations.
2. Ensure that the investment activities are funded by stable liabilities.
3. To limit the over-reliance on wholesale short-term funding (money market)
Available amount of stable funding
Required amount of stable funding

*must be greater than 1

Stable funding:
o
equity and any liability maturing after one year
o
90% of retail deposits
o
50% of deposits from non-financial corporates and public entities
Long-term uses:
o
5% of long-term sovereign debt or equivalent with 0%-Basel II Standard
approach risk-weighting (see comment above for LCR) with a residual maturity
above 1 year
o
20% of non-financial corporate or covered bonds at least rated AA- with a
residual maturity above 1 year
o
50% of non-financial corporate or covered bonds at least rated between A- and
A+ with a residual maturity above 1 year
o
50% of loans to non-financial corporates or public sector
o
65% of residential mortgage with a residual maturity above 1 year
o
5% of undrawn credit and liquidity facilities

Required Stable Funding

The required amount of stable funding is calculated as the sum of the value of the assets
held and funded by the institution, multiplied by a RSF factor, added to the amount of OBS
activity (or potential liquidity exposure) multiplied by its associated RSF factor.
C. Systematic Risk Interconnectedness (Counterparty risk)

Capital incentives for using CCPs for OTC

Higher capital for systemic derivatives
Higher capital for inter-financial exposures
Contingent capital
Capital surcharge for systemic banks

Basel III introduces a paradigm shift in capital and liquidity standards. It was constructed
and agreed in relatively record time which leaves many elements unfinished because the final
implementation dates a long way off. However, Market pressure and competitor pressure
already driving considerable change at a range of firms. Firms therefore should ensure to
engage with Basel III as soon as possible to be competitively advantaged in the new post-crisis
financial risk and regulatory landscape.
References:
http://www.investopedia.com/terms/b/baseliii.asp
http://www.basel-iii-accord.com/
http://treasurypeer.com/dummies-2/basel-3-for-dummies/
http://www.basel-iii.worldfinance.com/
http://www.bsp.gov.ph/regulations/implementation.asp
http://www.slideshare.net/ReadingLLMlegaleagles/basel-iii-presentation-15778472