A Guide on Basel III: History, Compliance and Requirements

Introduction

The global financial crisis of 2008 exposed the deep vulnerabilities of the financial landscape. What began as a liquidity problem in some banks soon had a cascading impact on countries and financial institutions all around the world. The crisis exposed poor liquidity management practices in financial institutions and uncovered the risks they posed. 

A major aspect that the crisis taught was that solely relying on measures specific to capital regulation was not sufficient to ensure the financial stability of banks. To prevent further such crises and safeguard financial institutions, the need for robust liquidity risk management was realized. 

While Basel I and Basel II regulations provided a framework focused on capital regulation, there were no internationally agreed-upon measures and standards for liquidity management. This paved the way for the Basel Committee on Banking Supervision (BCBS) to issue guidelines on “Basel III: International Framework for Liquidity Risk Measurement, Standards, and Monitoring” in December 2010.

In this blog, we will discuss the history of Basel III, the reason it was implemented, and the key principles and requirements of the accord. 

What is Basel III?

Basel III is the third iteration of the Basel Accord, a regulatory framework that is designed to improve the banking sector’s ability to manage liquidity and build a resilient standard worldwide. It builds upon its predecessors, Basel I and II, and introduces more firm regulations and risk management practices for banks.

Basel III was introduced to address the challenges that came to light during the 2008 global financial crisis. This framework was designed with the goal of assisting banks and financial institutions in preparing for any potential future crises through the implementation of universal practices and measures. This accord aims to maintain financial stability by helping the banks absorb risks and shocks better, mitigating risks, and ensuring robust risk management practices. 

History and Date of Implementation of Basel III

The global economic crisis of 2008 caused the formation of the Basel III accord. The history of Basel III can be backtracked by the crisis. The global financial crisis originated from the mortgage market in the United States, and the major reasons behind the crisis were: 

• Development of new products like mortgage-backed securities (MBS), collateralized debt obligations (CDOs), CDO squared, and other complex types of financial instruments. 
• Banks were continuously suffering heavy losses in their trading books. 
• The capital charge framework for market risk did not keep pace with the new market developments and practices. 
• Banks did not have adequate capital to cover the losses. 
• Heavy reliance on short-term wholesale funding. 
• Inadequate corporate governance and a lack of transparency in the banking sector. 

Though regulatory frameworks, Basel I and Basel II already existed, they proved to be insufficient to handle the crisis. These frameworks primarily focused on capital regulation and did not adequately address other crucial risk factors like liquidity and leverage. Basel II’s reliance on banks’ internal risk models proved flawed during the crisis, and the frameworks lacked specific guidelines for liquidity risk management. Additionally, they did not effectively address systemic risks posed by important financial institutions and failed to require sufficient capital buffers. As a result, Basel III was introduced in December 2010 by the Basel Committee on Banking Supervision (BCBS) to address these shortcomings by introducing more robust risk assessment methodologies, liquidity standards, systemic risk oversight, and higher capital requirements to enhance financial stability and prevent future crises.

The development of Basel III took several years and involved comprehensive consultations and discussions among central banks, regulatory bodies, and industry stakeholders. The final regulations are set to be released and implemented by July 1, 2025. However, the implementation of Basel III has been a phased process, and the specific dates for implementation vary across jurisdictions.

What are the Basel III Requirements? 

Effective implementation of Basel III was necessary to recover from the crisis and develop resilience to future shocks. Some of the key requirements of Basel III are discussed below: 

Capital adequacy requirements

The big banks faced a crisis in 2008, largely due to poor capital quality and insufficient capital levels. Basel III has made a significant change in terms of regulatory capital. 

Tier 1 and Tier 2 are two types of assets held by banks. Tier 1 capital represents a bank’s core capital, while Tier 2 capital represents supplementary capital. Tier 2 capital provides additional loss-absorbing capacity but is considered less secure than Tier 1 capital. Basel III introduces the concept of common equity Tier 1 (CET1). CET 1 includes capital such as equity shares and retained earnings. The minimum capital requirements under Basel III are as follows: 

• Common Equity Tier 1 must be at least 4.5% of risk-weighted exposures at all times.
• Additional capital conservation buffer of 2.5%
• Total capital (Tier 1 capital + Tier 2 capital) must be at least 8.0% of risk-weighted exposure at all times.

Liquidity standards 

Basel III introduced two key liquidity ratios: Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR requires banks to hold a sufficient amount of high-quality liquid assets to meet their liquidity needs over a 30-day stress period. A bank that maintains a ratio of more than a hundred percent during a short period of time is considered to be a sound bank in terms of short-term liquidity. 

The NSFR aims to ensure banks have stable funding sources relative to their long-term assets. The ratio was developed to address the maturity mismatch between liabilities and assets in the financial sector and to make sure that banks have sufficient stable funding to withstand a yearlong liquidity crisis.

Leverage ratios 

Banking systems had high levels of leverage, both on and off their balance sheets, during the economic crisis. This was evident when some globally active banks had leverage exceeding 50 times their capital, yet they still met the minimum capital adequacy standards. 

Basel III introduced a leverage ratio as another response to the financial crisis. It introduced a minimum leverage ratio to limit excessive leverage in the banking system. The leverage ratio is a non-risk-weighted measure that compares a bank’s Tier 1 capital to its average total consolidated assets. It aims to provide transparency in terms of the bank’s leverage and helps to support the risk-weighted capital requirements. 

Impact of Basel III on Banks 

In simple terms, Basel III will require banks of all sizes to maintain higher capital ratios and greater liquidity as a safety measure. Let’s discuss the impact of Basel III on banks of all sizes:

Big banks

• Capital adequacy requirements will necessitate big banks to raise additional capital or adjust their capital structure.
• Enhanced risk management practices, including advanced models and stress testing, may require significant investments in technology and expertise.
• Compliance costs can be significant, potentially providing big banks with a competitive advantage over smaller players.
• Business models may be influenced, potentially leading to adjustments in risk appetite and activities.

Mid-Sized banks 

• Mid-size banks may also face challenges in meeting the higher capital requirements, although their scale may be smaller compared to big banks.
• Enhanced risk management practices may require investments in systems and expertise, but potentially at a relatively lower scale compared to big banks.
• Compliance costs can still be significant for mid-size banks, which may require careful resource allocation.

Small banks 

• Smaller banks could encounter difficulties in fulfilling the increased capital requirements due to their limited access to capital markets.
• Risk management practices may need to be enhanced, but at a scale suitable for their operations and risk profile.
• Small banks may find compliance costs to be quite inconvenient since they may have few resources to dedicate to regulatory compliance.

How HighRadius Helps Banks Comply with Basel III 

As the deadline for complete implementation of Basel III approaches, financial institutions are actively looking to modernize their legacy systems and adopt measures to achieve greater operational efficiencies and facilitate capital optimization. The key to ensuring compliance with Basel III reforms lies in automating processes and ensuring better risk assessments. 

HighRadius’ Cash Management Solution allows seamless connectivity between multiple bank accounts. By leveraging Bank Connectivity Manager, businesses can establish secure connections between their financial systems and banking institutions, enabling real-time access to transaction data and account balances. This immediate access empowers companies to monitor their liquidity positions accurately, a critical requirement under the Basel III framework. 

Additionally, bank integrations facilitate enhanced cash visibility by consolidating data from multiple bank accounts into a centralized Bank Balance Management platform. By automating reporting processes and providing timely, accurate data for cash forecasting, these integrations streamline compliance efforts, enabling companies to uphold Basel III standards while optimizing their financial operations for stability and resilience. 

FAQs

1) What is the minimum capital adequacy ratio under Basel III?

The minimum capital adequacy ratio under Basel III requires banks to maintain at least 8%. This means that banks are required to maintain a minimum level of capital equivalent to at least 8% of their risk-weighted assets to ensure financial stability and resilience.

2) What is Basel III compliance?

Basel III compliance refers to the regulatory framework developed by the Basel Committee on Banking Supervision. It sets standards for banks’ capital adequacy, liquidity management, and risk governance. It involves meeting minimum capital requirements, implementing risk management practices, and guidelines for liquidity ratios.

3) Which banks are Basel III compliant?

Basel III is a global regulatory framework that sets standards for banks worldwide. All the major international banks, of all sizes, are subject to Basel III compliance. The specific list of Basel III-compliant banks would encompass a wide range of institutions across various countries and regions.

4) What is the difference between Basel I, II and III?

Basel I focused on minimum capital requirements based on credit risk. Basel II introduced more comprehensive risk management guidelines, including credit, market, and operational risks. Basel III enhanced capital requirements, introduced liquidity standards, and emphasized risk management and transparency of the banking system.