Basel III means new capital reserve guidelines

In September, after years of evaluation and consideration, global banking regulators agreed upon new rules representing the biggest change in global banking regulation in decades, a new international regulatory framework referred to as Basel III. The Basel Committee on Banking Supervision, which sets minimum banking standards for the international banking community, has been working to hammer out new international banking regulations designed to make the international financial system more resilient and prevent a repeat of the international credit crisis.

The Basel Committee consists of regulatory and central bank representatives from 27 countries. Its work is overseen by the Group of Governors and Heads of Supervision, chaired by Jean-Claude Trichet, president of European Central Bank, and including other leading governors such as Federal Reserve chairman Ben Bernanke. These reform recommendations were approved by the Group of Leading Countries (G20) at its November summit in Seoul, South Korea.

New capital requirements

As approved, Basel III guidelines set tougher bank capital and liquidity standards and require banks to increase significantly the amount of capital they hold in reserve. Under the current Basel II global accord, banks are required to hold top-quality capital totaling 2 percent of their risk-bearing assets. The US has been slow to implement Basel II reforms, with the largest US banks scheduled to complete the process by the first quarter of 2011, four years after many European countries put the rules into effect.

Under Basel III, banks will be required to hold top-quality capital – known as “core Tier 1” capital and consisting of equity or retained earnings – worth at least 4.5 percent of assets, calculated according to the riskiness of the assets on their books. Banks can include deferred tax assets, mortgage-servicing rights and investments in financial institutions to an amount no more than 15 percent of the common equity component. On top of that, banks will also have to build a new, separate “capital conservation buffer” of common equity of 2.5 percent of assets, bringing the total capital requirement to 7 percent. When credit markets are booming, as determined by national regulators, banks will also be required to build a separate “countercyclical buffer” of between zero and 2.5 percent.

Banks will be allowed to draw on the capital conservation buffer in times of financial stress. However, if a bank approaches the minimum requirements or fails to stay above the buffer, it could face restrictions curbing payouts such as bonuses, dividends, and share buybacks.

Timetable

In order to comply with these new requirements, the largest banks may need to raise hundreds of billions in capital. To ease this burden and give them time to do so, regulators created transition periods for phasing in the new rules. National implementation by Basel Committee member countries will begin January 1, 2013. Before that date, they will need to translate the rules into national laws and regulations. The Tier 1 capital rule will take full effect in January 2015, with the capital conservation buffer requirement scheduled to be phased in between January 2016 and January 2019. In response to the new regulations, some banks believe that meeting the new requirements may mean reduced levels of available money to make loans, possibly resulting in slower economic growth. The Basel Committee hopes that the transition periods will enable the banks to meet the new standards without slowing the economy.

In 2009, blaming the global credit crisis partly on risky trading by banks, the leaders of the G20 called on regulators to work on tougher bank capital rules and to help ensure that banks are in a better position to withstand periods of economic and financial stress. Regulators hope the Basel III reforms will encourage banks to pursue less risky business strategies and ensure they have enough reserves to weather financial downturns without needing taxpayer bailouts. Now that the reforms have been approved by the G20, banks must look to the next steps – effective implementation of globally accepted policies and procedures for capital adequacy.