What is Basel III?
Basel III is an international set of banking rules created to make large banks safer. It requires banks to hold higher amounts of high-quality capital and to meet new limits on leverage and short-term funding stress. The package of reforms aims to reduce the chance that banks’ losses will spill over to the wider economy.
Key definitions
– Risk-weighted assets (RWA): A bank’s assets adjusted by their riskiness. Safer assets (e.g., government bonds) receive lower weights; riskier loans receive higher weights.
– Capital ratio: The bank capital divided by its RWA, expressed as a percentage. Regulators set minimum capital ratios so banks can absorb losses.
– Capital buffer: Extra capital over the minimum required to help the bank survive adverse conditions.
– Leverage ratio: Simple measure of capital relative to total (non-risk-weighted) assets; it limits excessive balance-sheet expansion.
– Liquidity requirements: Rules that make sure a bank holds enough liquid assets to meet short-term outflows.
Short history (context)
– Basel I (1988): Introduced the first international minimum capital rule — banks were required to hold 8% of RWA as capital.
– Basel II (2004): Expanded risk measurement to include operational and market risks and encouraged banks to use internal models to estimate risk.
– Basel III (post-2007–2009 crisis): Strengthened capital quality and quantity, added leverage and liquidity standards, and addressed system-wide risk. The final elements agreed internationally in 2017 have been referred to in the U.S. as “Basel III Endgame.”
How Basel III works (high level)
– Capital quality and quantity: Banks must hold higher amounts of loss-absorbing capital, and a greater share of that capital must be common equity (the highest quality).
– Capital buffers: On top of minimums, banks hold buffers that can be drawn down in stress without requiring emergency government aid.
– Leverage and liquidity: New measures limit leverage (simple capital vs. total assets) and require sufficient high-quality liquid assets to survive short-term funding shocks.
– Supervision and calibration: National regulators (central banks and banking supervisors) translate the international standards into local rules and timelines.
Basel III Endgame and the U.S. implementation
– In the U.S., the Federal Reserve, FDIC, and OCC are the main implementers of the final
Basel III rules. Those agencies translate the Basel framework into U.S. regulation through proposed and final rulemakings, guidance, and supervisory expectations. Implementation choices — such as which size of banks must use internal risk models versus standardized approaches, how to calibrate buffers for systemically important banks, and how to treat specific exposures — are set at the national level and can differ from the Basel text.
Key implementation items and practical effects
– Output floor (capital floor). The Basel “output floor” limits how much lower a bank’s risk-weighted assets (RWA) can be when computed using internal models versus the standardized method. The Basel finalization sets the floor at 72.5% of standardized-RWA. Practical effect: banks that relied heavily on internal models will have higher reported RWAs and therefore lower risk-based capital ratios after the floor is applied.
– Worked example: Bank A reports common equity tier 1 (CET1) capital of $50 billion. Its internal-model RWAs are $400 billion; the standardized-RWA amount is $600 billion. The output floor requires RWAs ≥ 72.5% × $600bn = $435 billion. CET1 ratio before floor = 50 / 400 = 12.5%. After floor = 50 / 435 ≈ 11.49%. That’s a meaningful decline in the regulatory CET1 ratio.
– Leverage measures. Basel III introduced a simple leverage ratio (Tier 1 capital divided by total exposures) to limit build-up of leverage independent of risk models. The U.S. applies this plus a supplemental leverage ratio (SLR) for large, complex banks. These are simpler, model-free constraints and are especially relevant for banks with large off-balance-sheet activity.
– Quick calc: Tier 1 capital $60bn, total leverage exposure $1,000bn ⇒ leverage ratio = 60 / 1,000 = 6.0%.
– Liquidity rules. Basel introduced the Liquidity Coverage Ratio (LCR) — high-quality liquid assets (HQLA) / net cash outflows over 30 days — and the Net Stable Funding Ratio (NSFR) — available stable funding / required stable funding over one year. U.S. regulators enforce versions of these standards for large banks; smaller banks face lighter requirements.
– Capital quality and buffers. The Basel framework emphasizes common equity as the highest-quality capital and sets capital conservation buffers and countercyclical buffers. U.S. supervisors also apply surcharges for Global Systemically Important Banks (G-SIBs).
– Reduced reliance on internal models. The standardized approaches were strengthened to reduce variability in RWAs across banks and jurisdictions, which improves comparability but can raise RWAs for some institutions.
How to evaluate a bank under Basel III — step-by-step checklist (for analysts and students)
1. Gather the bank’s most recent regulatory filings: CET1, Tier 1, total capital, RWAs, leverage ratio, LCR, NSFR, and any G-SIB surcharge disclosures (sources: bank 10-Q/10-K, FR Y-9C for U.S. bank holding companies).
2. Compute key ratios:
– CET1 ratio = CET1 capital / RWAs.
– Tier 1 leverage ratio = Tier 1 capital / total leverage exposure.
– LCR = HQLA / net 30‑day cash outflows.
3. Check whether the bank reports both internal-model RWAs and standardized RWA figures. If so, compute the effective output-floor RWA = max(internal RWA, 72.5% × standardized RWA).
4. Recalculate CET1 using the output-floor RWA to see the capital impact.
– Example: Using the worked example above, show the pre- and post-floor CET1 ratios and the percentage point decline.
5. Confirm buffer status: compare CET1 ratio to sum of minimum CET1 requirement and conservation + G-SIB surcharge to determine usable buffer capacity.
6. Review trend: compare ratios over several quarters to detect capital depletion or replenishment, and check regulatory communications for planned or required remediation.
7. Read the regulator’s stress-test and capital planning outcomes (e.g., CCAR for U.S. large banks) to understand supervisory judgments about capital adequacy.
Practical implications for markets and bank behavior
– For banks: higher and higher-quality capital, more liquidity, and less reliance on internal models typically increase resilience but may raise funding costs and reduce return on equity. Some banks shift business mix toward lower-risk, lower-capital-intensity activities.
– For investors and creditors: standardized measures and the output floor improve comparability across banks but require analysts to look beyond headline capital ratios to the composition of capital and RWAs.
– For the economy: stricter capital and liquidity requirements reduce the risk
of systemic banking crises but can also constrain credit availability, raise borrowing costs, and amplify economic cycles if banks pull back lending in downturns. Policymakers try to offset those trade‑offs with countercyclical buffers, targeted macroprudential tools, and phased implementation to avoid undue credit contraction.
Implementation challenges and common criticisms
– Complexity and calibration. The Basel framework is technical, with many interacting buffers, ratios, and definitions (e.g., various capital tiers, RWA calculations, leverage exposure). Calibration choices—how high buffers should be and how RWAs are calculated—affect banks differently and can be controversial.
– Cross‑jurisdictional differences. National regulators translate Basel rules into local law and may phase in or tweak requirements. That reduces regulatory arbitrage in theory but can complicate comparability across banks in different countries.
– Reliance on risk models. Even with an output floor and standardized backstops, internal risk models remain important for many banks. Model errors or optimistic assumptions can understate risk weights.
– Impact on smaller banks. High fixed compliance costs and model‑related burdens can be proportionally heavier for smaller or regional banks, leading some regulators to adopt scaled approaches.
– Procyclicality. Risk weights and buffers tied to economic cycles can exacerbate contractions; countercyclical capital buffers are designed to mitigate this but depend on timely supervisory action.
Practical checklist for analysts and traders (step‑by‑step)
1. Start with headline ratios:
– CET1 ratio = CET1 capital / RWAs. Verify it exceeds minimums plus buffers.
– Tier 1 and total capital ratios similarly (Tier 1 capital / RWAs).
– Leverage ratio = Tier 1 capital / leverage exposure (non‑risk‑weighted). Know the jurisdiction’s minimum.
– LCR (liquidity coverage ratio) = HQLA / 30‑day net cash outflows (target ≥100%).
– NSFR (net stable funding ratio) = available stable funding / required stable funding (target ≥100%).
2. Check composition of capital:
– How much is CET1 vs. Additional Tier 1 (AT1) vs. Tier 2. CET1 is highest quality (retained earnings, common shares).
– Look for instruments that can be written down or converted (AT1) and recent issuances.
3. Review buffers and overlays:
– Capital conservation buffer (usually 2.5% CET1).
– Countercyclical buffer (jurisdictional, 0–2.5% CET1).
– Any G‑SIB (global systemically important bank) surcharge applicable.
4. Inspect RWAs and model changes:
– Year‑over‑year RWA growth: is it driven by balance‑sheet growth or model/parameter changes?
– Note any movement toward standardized approaches or the effect of the output floor.
5. Test sensitivity:
– Apply hypothetical shocks (e.g., 10% loan loss increase) to see capital impact.
6. Read supervisory disclosures:
– Pillar 3 reports, regulatory filings, and stress‑test results (e.g., CCAR in the U.S.).
7. Watch market signals:
– Credit spreads on bonds and CDS, equity price reactions, and deposit flows can provide early warnings.
8. Document assumptions and caveats:
– Be explicit about model differences, accounting treatments, and any transitional rules in effect.
Worked numeric examples
Example 1 — CET1 ratio
– CET1 capital = $
CET1 capital = $7,500 million
RWA = $50,000 million
CET1 ratio = CET1 / RWA = $7,500 / $50,000 = 0.15 = 15%
Step: apply a simple credit shock
– Assume a one‑time credit loss that reduces CET1 by $500 million (this is after any tax effect and after any provisions already recorded; real accounting timing may differ).
– New CET1 = $7,500 − $500 = $7,000 million
– New CET1 ratio = $7,000 / $50,000 = 0.14 = 14%
Step: apply an output‑floor / standardized RWA effect
– If the standardized approach would produce higher RWAs (for example, standardized RWA = $60,000 million because of the output floor), the CET1 ratio becomes:
– CET1 ratio (with output floor) = $7,500 / $60,000 = 0.125 = 12.5%
Key takeaway: the same CET1 capital can imply materially different capital ratios if RWAs rise because of balance‑sheet growth, model/parameter changes, or regulatory floors.
Example 2 — Leverage ratio (simple on a consolidated basis)
– Definition: leverage ratio = Tier 1 capital / exposure measure (where exposure measure = on‑balance sheet assets + certain off‑balance items).
– Tier 1 capital = $9,000 million
– Exposure measure = $120,000 million
– Leverage ratio = $9,000 / $120,000 = 0.075 = 7.5%
Sensitivity: if off‑balance sheet exposures increase (e.g., more derivatives or repo financing) so exposure measure = $150,000 million,
– Leverage ratio = $9,000 / $150,000 = 0.06 = 6.0%
Example 3 — Decomposing year‑over‑year RWA changes
Start values:
– Credit RWA = $40,000
– Market RWA = $5,000
– Operational RWA = $5,000
– Total RWA = $50,000
Observed year‑end total RWA = $57,000 (+$7,000)
Step 1 — quantify balance‑sheet growth (pure volume):
– If loan balances increased 5% and credit RWA moves proportionally, volume effect = 5% × $40,000 = +$2,000
Step 2 — quantify parameter/model changes (risk weight increases):
– Remaining RWA growth = $7,000 − $2,000 = $5,000 => attributable to higher risk weights / model changes / reclassification
– Check: did market RWA or operational RWA change? If market RWA rose from $5,000 to $6,500 (+$1,500), then model/parameter change in credit RWA = $5,000 − $1,500 = +$3,500
Step 3 — check for regulatory drivers:
– If an output floor increased RWAs to at least $55,000, then part of the $7,000 rise is due to the floor (record the floor amount separately).
Practical sensitivity test checklist (apply systematically)
1. Start with reported CET1, Tier 1, total capital, and disclosed RWAs by bucket.
2. Apply a plausible shock vector:
– Credit: increase default rate or loss‑given‑default (LGD) on a loan cohort.
– Market: increase VaR/scenario P