Basel III

The Basel III International regulatory framework for banks

"Basel III" is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector.

Overview

The International Regulatory Framework for Banks (Basel III)

The origins and aims of Basel III

In 1974, in response to disruptions in the international financial markets, the central bank governors of the G10 countries established a Committee on Banking Regulations and Supervisory Practices, later renamed as the 'Basel Committee on Banking Supervision' (BCBS). The Committee was designed as a forum for regular cooperation between its member countries on banking supervisory matters. Its aim was and is to enhance financial stability by improving supervisory knowhow and the quality of banking supervision worldwide.

The Basel Committee today

After starting life as a G10 body, the Committee expanded its membership in 2009 and now includes 27 jurisdictions. The Committee now reports to an oversight body, the Group of Central Bank Governors and Heads of Supervision (GHOS), which comprises central bank governors and (non-central bank) heads of supervision from member countries.

The Committee's decisions have no legal force. Rather, the Committee formulates supervisory standards and guidelines and recommends statements of best practice in the expectation that individual national authorities will implement them.

Basel III capital and liquidity standards

Following on from the capital adequacy frameworks announced in 1988 and 1999 (Basel I and Basel II respectively), in September 2010, the GHOS announced higher global minimum capital standards for commercial banks ('Basel III'). In November 2010, the new capital and liquidity standards were endorsed at the G20 Leaders Summit in Seoul.

Basel III is a comprehensive set of reform measures, developed to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to:

  • Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source
  • Improve risk management and governance
  • Strengthen banks' transparency and disclosures

The reforms target:

  • Bank-level, or micro-prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.
  • Macro-prudential, system-wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time

These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks.

The Bank for International Settlements has listed the Compilation of documents that form the global regulatory framework for capital and liquidity.

In the European Union, Basel III has been implemented via the CRD IV package.

Last updated: 9 July 2015

Capital

Basel III Capital requirements

Background

The final 'Basel III' capital measures were agreed by the group of central bank Governors and Heads of Supervision (GHOS) in September 2010, endorsed by G20 leaders in Seoul in November 2010, and published on 16 December 2010. The reforms cover both micro-prudential measures, to make individual banks more resilient; and macro-prudential measures, to reduce systemic risk.

Like Basel II, Basel III requires minimum capital ratios, defined as capital divided by risk-weighted assets. Basel III tightens the definitions of both capital and risk-weighted assets, and raises the minimum capital ratios required. Capital will now focus more tightly on common equity; and risk-weights for capital market activities will be increased.

Basel III Capital requirements

Under Basel III, it was agreed that from 2015 banks will need to maintain a regulatory minimum capital requirement as follows: a 4.5% Common Equity Tier 1 (CET1) ratio (which is a ratio of capital to risk weighted assets (RWAs)); a 6% Tier 1 capital ratio; and an 8% total capital ratio. In addition, a capital conservation buffer of 2.5%, comprised of CET1, will be established above the regulatory minimum capital requirements outlined above. Capital distribution (e.g. dividends and bonuses) constraints will be imposed on a bank when capital levels fall within this range. This new capital conservation buffer requirement is intended to be phased in between 2016 and 2019.

The new ratios compare to Basel II requirements of 2% of common equity, and 4% of Tier 1 capital, based on less stringent definitions. The Basel Committee is currently looking at common definitions of risk weights.

On 25 June 2011, the GHOS agreed to require G-SIFIs to hold 1% to 2.5% (with an empty bucket of 3.5%) of extra CET1 capital ratio on top of the base of 7% CET1 capital requirement (4.5% minimum CET1 ratio and a 2.5% capital conservation buffer). This new G-SIFI requirement will be phased in between 2016 and 2019. HSBC is currently designated to the 2.5% bucket.

In addition, the Basel framework requires banks to build up a counter-cyclical buffer of additional capital in good times, to be released as and when losses occur in bad times.

The CRD IV package in Europe

On 17 July 2013, the CRD IV package which transposes - via a Regulation and a Directive - the new global standards on bank capital (the Basel III agreement) into EU law, entered into force. The rules, which have applied from 1 January 2014, tackle some of the vulnerabilities shown by the banking institutions during the crisis, namely insufficient levels of capital, both in quantity and in quality, which previously resulted in the need for unprecedented support from national authorities. They also set stronger prudential requirements for banks, requiring them to keep sufficient capital reserves.

Prudential Regulation Authority (PRA) in the UK

The PRA has published its expectations in relation to capital ratios for major UK banks and building societies, namely that, from 1 July 2014, capital resources should be held equivalent to at least 7% of RWAs using a CRD IV end point definition of CET1. This PRA capital guidance applies instead of the minimum 4% CET1 transitional ratio applicable during 2014 under CRD IV.

Despite both the CRD IV and PRA rules published to date there remains continued uncertainty around the amount of capital that UK banks will be required to hold. This relates specifically to the quantification and interaction of capital buffers and Pillar 2, on which the PRA consulted earlier in 2015.

Federal Reserve Board alignment in the US

In December 2013, the Federal Reserve Board issued a final rule that makes technical changes to its market risk capital rule to align it with the Basel III regulatory capital framework (the market risk capital rule is used by banking organisations with significant trading activities to calculate regulatory capital requirements for market risk).

The final rule also clarifies criteria for determining whether underlying assets are delinquent for certain traded securitisation positions. It also details disclosure deadlines and modifies the definition of a 'covered position'. The changes make the market risk capital rule consistent with the revised capital framework due to take effect in January 2015.

For more information about Basel III capital requirements, please visit the Bank for International Settlements (BIS) website.

Last updated: 9 July 2015

Liquidity

Basel III Liquidity:

Background

During the early "liquidity phase" of the financial crisis that began in 2007, many banks ? despite adequate capital levels ? still experienced difficulties because they did not manage their liquidity in a prudent manner. The crisis again drove home the importance of liquidity to the proper functioning of financial markets and the banking sector. Prior to the crisis, asset markets were buoyant and funding was readily available at low cost. The rapid reversal in market conditions illustrated just how quickly liquidity can evaporate and that illiquidity can last for an extended period of time.

The Basel Committee response

The difficulties experienced by some banks were due to lapses in basic principles of liquidity risk management. In response, as the foundation of its liquidity framework, the Committee in 2008 published Principles for Sound Liquidity Risk Management and Supervision ("Sound Principles"). The Sound Principles provide detailed guidance on the risk management and supervision of funding liquidity risk and were designed to help promote better risk management in this critical area.

To complement these principles, the Committee has in recent years further strengthened its liquidity framework by developing two minimum standards for funding liquidity, the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR).

Liquidity Coverage Ratio (LCR)

The full text of the revised Liquidity Coverage Ratio (LCR) was issued by the Basel Committee on 6 January 2013, following endorsement by its governing body - the Group of Central Bank Governors and Heads of Supervision (GHOS).

The LCR promotes the short-term resilience of a bank's liquidity risk profile. It does this by ensuring that a bank has an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted into cash easily and immediately in private markets to meet its liquidity needs for a 30 calendar day liquidity stress scenario. It was designed to improve the banking sector's ability to absorb shocks arising from financial and economic stress.

Once the LCR has been fully implemented, its 100 percent threshold will be a minimum requirement in times of market stability. During a period of stress, banks would be expected to use their pool of liquid assets, thereby temporarily falling below the minimum requirement. The GHOS agreed that the LCR should be subject to phase-in arrangements which align with those that apply to the Basel III capital adequacy requirements.

Timeline

The LCR is scheduled to be introduced in stages from 1 January 2015. The minimum requirement will begin at 60%, rising annually in equal steps of 10 percentage points to reach 100% on 1 January 2019 (as per the below table):

  2015 2016 2017 2018 2019
Minimum LCR requirement 60% 70% 80% 90% 100%

For more information on the LCR, please view the Liquidity Coverage Ratio disclosure standards document.

Net Stable Funding Ratio (NSFR)

The Net Stable Funding Ratio (NSFR) is the second of the minimum standards for funding liquidity. It is a longer term liquidity metric that will require banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities.

A sustainable funding structure is intended to reduce the likelihood that disruptions to a bank's regular sources of funding will erode its liquidity position in ways that could increase the risk of its failure and potentially lead to broader systemic stress. The NSFR limits overreliance on short-term wholesale funding, encourages better assessment of funding risk across all on- and off-balance sheet items, and promotes funding stability.

Timeline

On 22 June 2015, the Basel Committee on Banking Supervision issued the final Net Stable Funding Ratio disclosure standards, following the publication of the NSFR standard in October 2014.

In parallel with the implementation of the NSFR standard, supervisors will give effect to these disclosure requirements, and banks will be required to comply with them from the date of the first reporting period after 1 January 2018.

Last updated: 9 July 2015

Leverage
ratio

Basel III Leverage Ratio requirements

Why are leverage ratio rules important?

Leverage is the amount of debt used to finance a firm's assets. It is used as a measure of the resilience of a financial institution. The Basel III Leverage Ratio rules are intended to control the extent of actual and likely extension of financing against the capital of an institution without regard to the riskiness of the financing. Policy makers consider lower levels of leverage to be an important factor in reducing overall systemic risks, regardless of the riskiness of the underlying assets.

The Basel Committee believe that a simple leverage ratio framework is critical and complementary to the risk-based capital framework that will hopefully ensure broad and adequate capture of both the on- and off-balance sheet sources of banks' leverage. This simple, non-risk based 'backstop' measure will restrict the build-up of excessive leverage in the banking sector to avoid the destabilising deleveraging processes that can potentially damage the broader financial system and the economy.

How are leverage ratios calculated?

Basel III's leverage ratio is calculated by dividing the 'capital measure' (the numerator) by the 'exposure measure' (the denominator) and is expressed as a percentage. The capital measure is currently defined as Tier 1 capital and a minimum requirement of 3% for the leverage ratio is currently being tested / monitored.

The Committee will continue to monitor banks' leverage ratio data on a semi-annual basis in order to assess whether the design and calibration of a minimum Tier 1 leverage ratio of 3% is appropriate over a full credit cycle and for different types of business models. It will also continue to collect data to track the impact of using either Common Equity Tier 1 (CET1) or total regulatory capital as the capital measure.

Global proposals

Following the final Basel III measures which introduced a leverage ratio, the Committee has since released two revisions (in June 2013 and January 2014) which have largely redefined the methods for measuring exposure. On 12 January 2014, the Basel Committee issued the full text of Basel III's leverage ratio framework and disclosure requirements following endorsement by its governing body, the Group of Central Bank Governors and Heads of Supervision (GHOS).

The exposure is measured as a combination of: on-balance sheet exposures with no reduction for credit risk mitigation; derivative exposures, including a measure of potential future increases in value; securities financing transaction exposures, because they are a source of secured funding and leverage; and off-balance sheet exposures, such as facilities and guarantees. The measure is risk-insensitive ? it does not consider risk weights ? as credit worthiness is not considered relevant for leverage.

The Basel Committee continues to test a minimum requirement of 3% for the leverage ratio during the parallel run period (i.e. from 1 January 2013 to 1 January 2017). Any final adjustments to the definition and calibration of the leverage ratio will be made by 2017, with a view to migrating to a Pillar 1 (minimum capital requirement) treatment on 1 January 2018, based on appropriate review and calibration. The Committee will also closely monitor accounting standards and practices to address any differences in national accounting frameworks that are material to the definition and calculation of the leverage ratio.

EU proposals

Supervisory disclosure of the leverage ratio has been required since 1 January 2014 and public disclosure of the leverage ratio has been required from 1 January 2015. The leverage ratio delegated act under the Capital Requirements Regulation (CRR) came into force on 18 January 2015. This delegated act aims to align the leverage ratio definition in the CRR with the agreed Basel international standard issued in January 2014. By the end of 2016, the Commission will report to the European Parliament and Council on the impact and effectiveness of the leverage ratio and this may be accompanied by a legislative proposal, possibly including a mandatory leverage ratio to apply in Europe by 2018.

UK proposals

Major UK banks and building societies, including HSBC, are currently expected by the Prudential Regulation Authority to meet a 3% end-point Tier 1 leverage ratio (Basel 2014 basis). Also, in November 2013 the Chancellor of the Exchequer requested that the Financial Policy Committee ('FPC') undertake a review of the role of the leverage ratio within the capital framework. In July 2014, as part of this review, the FPC issued a consultation which proposes a more stringent leverage ratio regime in the UK.

On 31 October 2014 the FPC published its view on the calibration of a UK leverage ratio. This is yet to be implemented. In March 2015, HM Treasury published a statutory instrument for a UK leverage ratio framework. The instrument is now in force and grants the FPC powers of direction over a minimum leverage ratio and additional leverage buffers. The PRA expects to make rules, via public consultation, to implement the FPC's proposed leverage ratio framework. The exact timing and implementation of the FPC proposals before they become effective is still to be confirmed.

For more information on leverage requirements, please visit the Bank for International Settlements (BIS) website.

Last updated: 9 July 2015

Fundamental Trading Book Review

The BCBS' Fundamental Review of the Trading Book

Background

In May 2012, the Basel Committee on Banking Supervision released their Fundamental Review of the Trading Book consultative document, which set out a market risk framework and proposed a number of specific measures to improve trading book capital requirements.

These rules were reviewed as policy makers in both the US and UK believe that the current system of using in-house models to assign weightings to risky assets to establish capital levels is too complicated and can be easily manipulated by banks.

A 'trading book' is a portfolio of financial instruments held by a brokerage or bank. Financial instruments in a trading book are purchased or sold to facilitate trading for the institution's customers, to profit from trading spreads between the bid and ask prices, or to hedge against a number of types of risk. Trading books can range in size from hundreds of thousands of dollars at the smallest institutions to tens of billions at the largest financial institutions. The majority of financial institutions employ sophisticated risk metrics to manage and mitigate risk in their trading books.

The aim of this new regulatory framework is to address weaknesses in risk measurement under the internal models-based and standardised approaches currently used, with a view to promoting consistent implementation across jurisdictions.

On 31 October 2013, the Committee issued a second consultative document setting out a draft text for a revised market risk framework, and included comments received on the first consultative paper, and lessons learnt from the Committee's investigations into the variability of market risk-weighted assets.

The Basel Committee published a third consultation paper in December 2014 which lays out a limited set of new revisions to the proposed market risk framework. The deadline for comment was 20 February 2015.

About the Review:

The third consultation paper introduces refinements in the below areas:

  • Treatment for internal risk transfers (IRTs) of equity risk and interest rate risk between the banking book and the trading book, to supplement the existing treatment of internal transfers of credit risk. The objective of IRT provisions is to limit opportunities for capital arbitrage between banking book and trading book positions, while maintaining a transparent implementation of the revised boundary across jurisdictions.
  • A revised Standardised Approach that uses as inputs changes in the value of an instrument based on sensitivity to underlying risk factors. This Sensitivity-Based Approach (SBA) is an improved revision from the originally proposed 'cash flow' approach, which would have introduced significant system constraints. The updated approach allows for a more granular treatment of market risk factors; however, a number of outstanding concerns still remain including: treatment of securitization, curvature risk and the methodology for capturing this.
  • A simplified method for incorporating the concept of liquidity horizons in the Internal Models Approach (IMA). Liquidity horizons are the time required to liquidate exposure to certain 'risk factors' or asset classes in the market. Refinements have been made to reduce modelling complexity and data revalidation costs, with lower liquidity horizons introduced for certain FX currency pairs and interest rate risk. Back testing and the ability of firms to provide data on theoretical P&L attribution tests remain a concern. The consistency of the IDR and IRB for both PD and LGD is likely to significantly increase the charge if the 3bp PRA floor on LGD is applied.

The Committee is also considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach. However, it will only make a final decision on this issue following a comprehensive Quantitative Impact Study (QIS), after assessing the impact and interactions of the revised standardised and models-based approaches.

Latest:

The Basel Committee issued a third QIS (i.e. QIS 3) in December 2014. Due to lack of clarity in the second QIS instructions, data quality was generally poor throughout the industry. QIS3 was intended to provide more robust results and therefore more accurately capture the impact of the framework. HSBC participated in this exercise to assist in assessing the potential impact of the FRTB rules.

Results were submitted to the PRA on 10 April, which will be subsequently sent to the TBG for analysis. Following an early June high-level Basel Committee meeting, our understanding is that an additional quantitative exercise, potentially a QIS exercise, will be issued. The scope of this analysis is expected to include parameters where final calibration is deemed to be inappropriate (e.g. SBA, NMRF and securitisation).

For more information on the Fundamental Review of the Trading Book, please visit the Bank for International Settlements website .

Last updated: 9 July 2015

CRD IV

CRD IV

Background

On 17 July 2013, the CRD IV package which transposes - via a Regulation and a Directive - the new global standards on bank capital (the Basel III agreement) into EU law, entered into force. The rules, which have applied from 1 January 2014, tackle some of the vulnerabilities shown by the banking institutions during the crisis which resulted in the need for unprecedented support from national authorities. They set stronger prudential requirements for banks, requiring them to keep capital reserves which are greater in amount, better in quality and more liquid in nature. This new framework aims to make EU banks more solid, strengthen their capacity to adequately manage the risks linked to their activities, and absorb any losses they may incur in doing business.

Why was CRD IV needed?

CRD IV is a revision of the original Capital Requirements Directive (CRD), which was deemed insufficient in light of the recent financial crisis. The quality and the level of the capital base, the availability of the capital base, liquidity management and the effectiveness of internal and corporate governance of some financial institutions were found to be inadequate and consequently, the decision was taken to replace the CRD with a new regulatory framework including a Regulation, the Capital Requirements Regulation (CRR), and a Directive, CRD IV.

CRD IV offers a number of enhancements to the previous legislation, notably:

  • Enhanced governance. CRD IV strengthens the requirements with regard to corporate governance arrangements and processes and introduces new rules aimed at increasing the effectiveness of risk oversight by Boards, improving the status of the risk management function and ensuring effective monitoring by supervisors of risk governance.
  • Enhanced transparency. CRD IV improves transparency regarding the activities of banks and investment funds in different countries, in particular as regards profits, taxes and subsidies in different jurisdictions. This is considered essential for regaining the trust of EU citizens in the financial sector.

 

Timeline and implementation of CRR and CRD IV

  • The new legislation entered into force on 17 July 2013.
  • Institutions are required to apply the new rules from 1 January 2014, with full implementation on 1 January 2019.
  • A number of CRD IV implementing measures still need to be finalised by the European Banking Authority.

For more information on CRD IV, please visit the European Union website.

Last updated: 9 July 2015