Basel III and its finalisation

Before 2008, a bank could meet the global rules with common equity of just 2% of its risk-weighted assets, counted before deductions. Basel III raised that to 4.5% after deductions, then put buffers on top. Why so much more, and what happens when a bank dips into them?

L2.7.03: Basel II: three pillars listed what the crisis exposed in Basel II: too little loss-absorbing capital, too much trust in models and ratings, and no liquidity rules. The Basel Committee's answer, published in December 2010 and revised in June 2011, is Basel III. It works on five fronts.

1. Quality of capital

Much of what counted as capital before the crisis, such as hybrid bonds that could not absorb losses while the bank was alive, failed when needed. Basel III puts the weight on Common Equity Tier 1Common Equity Tier 1: ordinary shares and retained earnings, after deductions such as goodwill. The highest-quality capital. (CET1), the shares and retained profits you met in L1.8.06: Capital, equity and leverage, and takes deductions such as goodwill from CET1 itself. Minimums, as a share of RWA: CET1 4.5%, Tier 1 6% (the rest as Additional Tier 1Additional Tier 1: perpetual instruments that are written down or converted into shares when the bank is in trouble.) and total capital 8%.

2. Buffers above the minimum

A minimum that a bank may never touch is of little use in a crisis. So Basel III adds CET1 buffers that a bank may use, at a price:

• the capital conservation bufferCapital conservation buffer: 2.5% of RWA in CET1 above the minimum, which a bank may use in bad times at the cost of limits on payouts., 2.5% for every bank;
• the countercyclical bufferCountercyclical capital buffer: an extra 0% to 2.5% of RWA, set by each national authority, raised when credit booms and released in a downturn., 0% to 2.5%, raised by national authorities when credit grows fast and released when it turns;
• a surcharge of 1% to 3.5% for each global systemically important bankGlobal systemically important bank: one of the largest, most connected banks, listed each year by the FSB and required to hold extra CET1., by its bucket on the FSB's annual list, with similar national surcharges for domestic systemically important banks.

Fall into the buffer and nothing breaks, but the bank must hold back part of its profits: the deeper it falls, the less it may pay out as dividends, share buybacks and bonuses. The cap is the maximum distributable amountMaximum distributable amount: the most a bank inside its buffers may pay out in dividends, buybacks and bonuses.. Try it here.

3. The leverage ratio

Risk weights can be wrong. The leverage ratioTier 1 capital divided by an exposure measure that ignores risk weights. Minimum 3%. from L1.8.06: Capital, equity and leverage ignores them: Tier 1 capital must be at least 3% of total exposure, including off-balance-sheet items. Since the 2017 package, G-SIBs add a leverage buffer of half their risk-based surcharge.

4. Liquidity rules, for the first time

L2.2.04: Liquidity risk showed how a bank can be solvent and still run out of cash. Basel III added two global liquidity standards. The Liquidity Coverage RatioLiquidity Coverage Ratio: HQLA divided by net cash outflows over a 30-day stress. Minimum 100%. (January 2013) asks whether a bank holds enough high-quality liquid assetsHigh-quality liquid assets: cash, central bank reserves and securities that can be sold quickly with little loss, even in a stress. to survive a 30-day stress: deposits leave at set rates, wholesale funding dries up. The Net Stable Funding RatioNet Stable Funding Ratio: available stable funding divided by required stable funding over one year. Minimum 100%. (October 2014) looks a year ahead: long-term, illiquid assets must be funded by stable money such as capital and retail deposits, not by overnight borrowing. Both must be at least 100%.

5. The finalisation, December 2017

Studies by the committee found that banks with similar portfolios reported very different RWA from their own models. The final package, sometimes called Basel IV by the industry, tightened the measurement of RWA:

A revised market risk framework (often called FRTB), first published in January 2016 and revised in January 2019, completes the set.

The CET1 test with all the buffers:

The two liquidity ratios:

And the output floor:

Shown in full: each is a ratio of weighted sums, like the Basel I ratio in L2.7.02: The Basel Committee and Basel I. If the percentages feel slippery, see M-A01: Percentages. The run-off rates and funding factors used below are the main ones in the BCBS standards; the full tables belong to Level 4: Regulation, Capital & Accounting.

This is Meridian Bank's liquidity position from the worked example. Lower its liquid assets until the LCR falls below 100%. Then shift funding from retail savers to other financial firms, and watch the outflows jump.

Meridian Bank is a made-up G-SIB in bucket 1 (1.5% surcharge), in a country with a 1% countercyclical buffer. It has €400bn of RWA, €48bn of CET1, €6bn of AT1, €8bn of Tier 2 and a leverage exposure of €900bn.

Basel III binds only once each jurisdiction writes it into law, and timetables differ. The EU uses its Capital Requirements Regulation and Directive (CRR and CRD), the UK the PRA Rulebook, and the US rules issued jointly by the Federal Reserve, the OCC and the FDIC (L2.7.07: The EU, UK and US landscape). The 2010 to 2014 standards are in force across the committee's members. The 2017 package was due from 1 January 2023; a few members applied it from then and more have followed since, while in the EU, UK and US parts were still being phased in or had been postponed at the time of writing. Implementation varies by jurisdiction, and the committee tracks it in regular progress reports.

• Basel III (December 2010, revised June 2011) puts CET1 at the core: minimums of 4.5% CET1, 6% Tier 1 and 8% total capital, after stricter deductions.
• Buffers sit above the minimum: 2.5% conservation, 0% to 2.5% countercyclical, and 1% to 3.5% for G-SIBs. Inside them, payouts are capped by quartile.
• The 3% leverage ratio is a backstop that ignores risk weights.
• The LCR (30-day stress) and NSFR (one-year funding) must each be at least 100%.
• The December 2017 finalisation reined in internal models, with a 72.5% output floor; its implementation varies by jurisdiction.

CET1

Common Equity Tier 1: ordinary shares and retained earnings, after deductions such as goodwill. The highest-quality capital.

Additional Tier 1

Additional Tier 1: perpetual instruments that are written down or converted into shares when the bank is in trouble.

Conservation buffer

Capital conservation buffer: 2.5% of RWA in CET1 above the minimum, which a bank may use in bad times at the cost of limits on payouts.

Countercyclical buffer

Countercyclical capital buffer: an extra 0% to 2.5% of RWA, set by each national authority, raised when credit booms and released in a downturn.

G-SIB

Global systemically important bank: one of the largest, most connected banks, listed each year by the FSB and required to hold extra CET1.

MDA

Maximum distributable amount: the most a bank inside its buffers may pay out in dividends, buybacks and bonuses.

Leverage ratio

Tier 1 capital divided by an exposure measure that ignores risk weights. Minimum 3%.

HQLA

High-quality liquid assets: cash, central bank reserves and securities that can be sold quickly with little loss, even in a stress.

LCR

Liquidity Coverage Ratio: HQLA divided by net cash outflows over a 30-day stress. Minimum 100%.

NSFR

Net Stable Funding Ratio: available stable funding divided by required stable funding over one year. Minimum 100%.

Output floor

Output floor: RWA from a bank's own models may not fall below 72.5% of the RWA the standardised approaches would give.