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Basel III: an overview
Basel III is a set of banking reforms with a focus on specific capital requirements. The purpose of these regulations is to reduce both operational risk and credit risk, and aid European banks in operating with stability. As shown by the 2020 financial crash, Basel III regulations have been key in reducing fall out when periods of financial stress occur.
History of Basel III
The Basel III framework was introduced by the Basel Committee on Banking Supervision (BCBS). The group was originally formed in 1974, but has continued to produce regulation in response to threats to the global banking system.
The forum-style committee produced Basel I and II regulatory requirements prior to Basel III. These two regulatory measures laid the initial frameworks for banks to begin mitigating risk in their lending practices.
The Basel III reforms were produced in response to the 2008 banking and financial crisis, which caused mass unemployment, EU bank closures and economic struggle. The purpose of this new regulation was to better protect the stability of the economy, and help investors to make more informed decisions.
Owing to delays caused by covid-19, the final Basel III will come into force on 1 January 2023, with a phased introduction over five years.
Key provisions of Basel III
Basel III was introduced to mitigate risks taken by banks when they lend money. This applies when lending to both consumers and businesses. Here are some of the regulatory requirements that promote long term financial stability:
Minimum Capital Requirement
The minimum capital requirement (MCR) refers to the actual cash or liquid asset value that a bank must hold at any point in time. This feature was raised from Basel II (where it was 2%) to 4.5% in Basel III, plus a buffer capital requirement of at least 2.5%.The reason for MCR is to reduce the intensity of impacts during times of financial stress.
Although these frameworks were introduced years ago, banks had until January 2022 to ensure everything is fully implemented. In response to the pandemic, this has been further extended.
The leverage ratio refers to “backstop capital”, which relates to the amount of lending taking place. It can help determine the maximum level of lending that a financial institution is able to endure while normal operations still occur.
In this case, the leverage ratio compares a bank’s core capital in relation to its total assets.
The leverage ratio was increased to at least 3% in Basel III regulation. However, the Federal Reserve ensures that banks have a fixed LR of at least 5-6% in the US.
The basic liquidity requirement of this feature is that banks must have enough liquid assets to be able to withstand a 30-day stressed funding scenario. These are considered a risk weighted asset. Further to this, banks must maintain the stable funding required for a minimum of a 1-year extended stress period.
Who must comply?
The Basel III regulatory framework applies to financial institutions in the UK and around the world. In fact, the release of Basel III in 2009 coincided with the expansion of the committee- expanding from just 10 to 29 countries.
Since the purpose of this regulation is to reduce risk, Basel III also applies to traders and partners in the banking sector. The regulation attempts to move risk and responsibility away from the banks in order to place charges and liability on trading partners.
The Basel III standard naturally reduces economic growth, since lending is restricted and banks must be more considerate in their approval to regulatory capital. Closer balance between capital and assets is likely to bring down the balance sheet. Financial institutions must consider this regulation, strategy and profitability in order to offset these losses.
Finally, having safer investment practices is likely to build a more informed investor. Basel III is a positive aspect of financial regulation in that it will improve long term stability and banking resistance in case of economic downturn.
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