In order to improve stability in the global financial system, the Bank for International Settlements established Basel III, a set of international banking regulations. The main goal of Basel III is to minimize economic damage caused by banks that take on too much risk. It was established in 2009 following the 2008 Global Financial Crisis with the goal of fortifying banks’ transparency and disclosure and improving banks’ ability to recover from financial stress shocks.
Basel III (preceded by Basel I and II) was created by the Basel Committee on Banking Supervision, or BCBS. The BCBS was established in 1974 by the Group of Ten (G10) countries in response to financial market disturbances. It was formed as a panel where member countries could debate matters regarding bank supervision. Currently, the BCBS is also responsible for strengthening global regulation, supervision, and banking practices to maintain financial stability. Currently, the committee includes the following areas:
- Hong Kong
- Saudi Arabia
- South Africa
- United Kingdom
- United States
The BCBS must report to the Group of Governors and Heads of Supervision (GHOS), which is based at the Bank of International Settlements (BIS) in the eponymous Basel, Switzerland. Since its initial establishment, Basel III has undergone several alterations and extensions.
The following lists and describes the main principles of Basel III
Minimum Capital Requirements
Basel II set the minimum capital requirement for banks at 2% of common equity (as a percentage of risk-weighted assets). However, Basel II has increased this to 4.5%. Additionally, Basell III institutes a 2.5% extra requirement, making the minimum requirement for Basel compliance to be 7%. The extra 2.5% can assist banks under financial duress, but it can also lead to more financial stress when paying dividends.
The Tier I capital requirement grew from 4% to 6% in 2015 (this is including the aforementioned 4.5% of Common Equity Tier 1 and an extra 1.5% of Tier 1 capital). Originally, banks were required to meet these standards in 2013, but they received an extension until 2022 to implement the changes.
To mitigate risks from the risk-based capital requirements, Basel III implemented a non-risk-based leverage ratio. Basel III requires banks to hold a leverage ratio greater than 3% and then calculates the non-risk-based leverage ratio by dividing Tier 1 capital by the average of all consolidated bank assets. In response, the United States Federal Reserve Bank has fixed the leverage ratio at 6% for Systematically Important Financial Institutions (SIFI) and 5% for bank holding companies that are insured.
Basel III introduced the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The former demands that banks maintain or exceed specified, highly liquid assets able to withstand a 30-day stressed funding scenario. The latter demands banks maintain stable funding beyond the required amount for one year of extended stress.
Potential Effects of Basel III
Although Basel III may marginally restrain economic growth, but it will ultimately create a safer financial system. Investors expect a variety of impacts including safer markets for bond investors and more stability for stock market investors.