An Overview of Basel III Framework

Basel III is a crucial regulatory response to the financial crisis and a major step forward towards creating a stronger and safer financial system. Basel III was developed expressly to reduce both the frequency and intensity of financial crisis. Studies indicate that the accord will lower the very significant economic costs of crisis. Such benefits will not materialize however unless we fully and consistently implement it; any weakening of the standards or delay in implementing them will only hinder efforts to restore confidence in the financial system.

Basel III substantially raises the quality and quantity of capital with a greater focus on common equity. The capital needs to be of the highest quality to better absorb losses from shocks that could emanate from anywhere. Basel III also introduces a simple leverage ratio which will act as a backstop to the risk-based measure. Such a measure is critical to underpinning the whole regime and will provide a simple and easy to understand sanity check of the results produced by the risk-based framework.

Basel III uses capital buffers. The conservation buffer provides a strong incentive for banks to build up capital in good times, while the counter-cyclical buffer should help protect banks against the dangers of rapid credit growth which might be particularly relevant for emerging economies. On top of that Basel III introduces sound liquidity risk management principles and global liquidity standards that will help banks more effectively manage this risk and maintain adequate liquidity buffers.

Some major differences after Basel III are:

1. Risk Management and Corporate Governance

The crisis showed that existing risk management systems could not cope with unforeseen stresses. However, systems alone were not to blame. Sound governance was often lacking. The Basel Committee recommendations in this regard are very clear.

2. Better and More Capital

Basel III raises the level and quality of capital in the system. When the whole Basel III package is implemented, bank's common equity will need to be atleast 7% of risk-weighted assets. This compares to a Basel II level of 2% common equity. And that's before taking account of the changes to definitions and risk-weights which make the effective increase in capital even greater. The 7% figure includes a 2.5% capital conservation buffer which is designed to be drawn on in difficult times and among improvements in capturing risk. On the asset side something worth mentioning is the stronger treatment of risks related to securitization and contingent credit lines. But what about the rest of Tier 1 and Tier 2 capital which amounts to another 3.5% of risk-weighted assets. The truth is that during the crisis some of the regulatory capital did not work as intended and did not absorb losses. A number of distressed banks had to be rescued by the public sector injecting capital. This had the effect of supporting not only depositors but also the investors in regulatory capital instruments.