Closing the Book on Basel III

In Thinking by New Link Editor

The fallout that unfolded as a result of the global financial crisis of 2007-08 demonstrated how truly interconnected the global financial system is. Consequentially, this prompted a global drive  toward financial regulatory convergence, addressing the primary causes of fragility in the international financial system. The Bank for International Settlements were responsible for this challenge, unveiling a package of minimum standards in 2010. Fast-forward seven years, and while Basel III continues to be implemented, after considerable negotiation between regulators the rules have only just been finalised. This blog summarises some of the main take-aways of the reforms announced on the 7th December 2017.

Brief Recap: What is Basel III

Finding its origins in the mid- 1970s, the Basel process enables monetary authorities and financial supervisory officials to share financial data and set international standards. Basel III is an extension of the previous Basel I and II Frameworks that had been agreed and implemented globally. It introduces new capital and liquidity standards to strengthen the regulation, supervision, and risk management of the whole of the banking and financial sector. This includes holding additional high-quality and liquid assets at all times to absorb losses during periods of financial and economic stress. Basel III also imposes limits on leverage to prevent excessive borrowing.

What did the Final Negotiations Focus on?

The final phase of Basel III focused on negotiating the reforms for the statistical models that banks use to calculate risk-weighted assets (“RWAs”). This is of considerable significance for banks since the calculation of the riskiness of each of their asset portfolios will determine how much regulatory capital they will be required to hold on their balance sheet.

Banks can calculate RWAs through either: (1) Standardised Approach, using model parameters set by regulators and relying on credit rating agency data (2) an Internal Model that allows for a more accurate representation of the riskiness of assets. From 1st January 2015, the Standardised Approach has applied to all banks which are subject to the Basel III US Final Rules. The use of Internal Models is only applicable to banks with consolidated assets greater than $250bn or with foreign exposures exceeding $10bn on their balance sheet. This was enforced on 1st January 2014.

Changes were deemed appropriate as a consequence of a growing body of research that has emerged[1], uncovering significant variations when calculating RWAs across banks when using internal models. Such variation cannot be adequately explained by differences in the riskiness of banks’ portfolios, suggesting that in some instances internal models have been used to drive capital requirements below levels that regulators consider appropriate.

The agreed upon response is to introduce an Output Floor that will prevent the RWAs calculated by the internal model being lower than 72.5% of the standardised approach. This amount was broadly in line with expectations and is expected to increase RWAs for European banks, subsequently increasing capital requirements[2]. Nevertheless, this was offset in large part by a longer transition period than expected, with incremental increases in the floor annually before the final implementation of the full 72.5% in 2027. A full timeline for the agreed upon reforms is provided below.

Implementation Timeline

The table below provides a timeline for the implementation of the Output Floor, as well as the other agreed upon reforms. If you would like to read more, please refer to the official Bank for International Settlement documentation[3] and continue to visit the New Link Consulting website.

2017 ReformsImplementation Date
Revised standardised approach for credit risk1 January 2022
Revised internal ratings-based framework for credit risk1 January 2022
Revised credit valuation adjustment framework1 January 2022
Revised operational risk framework1 January 2022
Revised market risk framework1 January 2022
G-SIB leverage ratio buffer1 January 2022
Output floor1 January 2022: 50%
1 January 2023: 55%
1 January 2024: 60%
1 January 2025: 65%
1 January 2026: 70%
1 January 2027: 72.5%

 

[1] For example, please see: Bank of International Settlements: Results of the Cumulative Quantitative Impact Study: [https://www.bis.org/bcbs/publ/d426.pdf]

[2] Bloomberg: Bank Regulators Seek Washington Breakthrough in Basel Talks

[https://www.bloomberg.com/news/articles/2017-10-10/global-bank-capital-rules-near-completion-10-years-after-crisis]

[3] Bank of International Settlements: Finalising Post-Crisis Reforms [https://www.bis.org/bcbs/publ/d424.pdf]