Basel III Endgame

Basel III Endgame

Subject: Economy

Sec: Monetary Policy

• Basel III Endgame: Overview:
  • The U.S. Federal Reserve has announced significant changes to a proposal for stricter bank capital requirements known as the “Basel III endgame.”
• What is Basel and Why is it Contentious:
  • The Basel Committee on Banking Supervision, convened by the Bank for International Settlements (BIS) in Basel, Switzerland, aims to ensure global regulators apply similar minimum capital standards for banks.
  • Basel III standards, agreed after the 2008 global financial crisis, include capital, leverage, and liquidity requirements.
  • The “endgame,” agreed upon in 2017, represents the final iteration of Basel III standards.
• Proposed Changes:
  • The U.S. proposal focuses on overhauling how banks assess risk and determine capital requirements.
  • Main areas of focus include credit risk, market risk, and operational risk.
• Credit Risk:
  • Regulators aim to end banks’ use of internal risk models for determining capital against lending activities like mortgages and corporate loans.
  • Federal Reserve Vice Chair Michael Barr cites the potential for banks’ internal models to underestimate risk.
• Market Risk:
  • Proposed changes include establishing new requirements for banks to assess risks from market fluctuations and trading losses.
  • Regulators suggest that current market risk assessments may be understated.
• Operational Risk:
  • A key new area of focus is operational risk, covering potential losses from internal policy failures, management errors, legal costs, or external events.
  • Regulators aim to replace existing internal models with a standardized approach to calculate capital levels.
• Industry Concerns:
  • Banks argue that the proposed changes would lead to unnecessary capital burdens and could impact the economy.
  • They have lobbied against the project, citing concerns about higher costs and potential limitations on fee income.
  • Some banks fear disproportionately higher capital requirements due to the proposed changes.
• Regulatory Response:
  • Regulators counter that banks are well-capitalized and can raise funds by retaining earnings for a short period.
  • The Fed and other regulators are expected to reduce the impact of the proposal in a significant rewrite.
  • Fed Chair Jerome Powell confirmed the expectation of “broad, material” changes to the plan.

The “Basel III endgame” represents a culmination of efforts to strengthen bank capital requirements globally.

The U.S. proposal, part of this initiative, aims to revise how banks assess and manage risks. While regulators stress the need for a robust financial system, banks argue that the changes could impose undue burdens. The ongoing review and expected revisions highlight the contentious nature of these regulatory reforms.

Basel Norms Overview:

• Basel norms, or Basel accords, are international banking regulations issued by the Basel Committee on Banking Supervision.
• They aim to coordinate banking regulations globally to strengthen the international banking system.

Basel Committee on Banking Supervision (BCBS):

• The BCBS is the primary global standard setter for the prudential regulation of banks.
• It provides a forum for cooperation on banking supervisory matters among central banks of different countries.
• Established by Central Bank governors of the Group of Ten countries in 1974.
• Expanded membership in 2009 and 2014; now has 45 members from 28 jurisdictions.

Objectives:

• Enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.
• Ensure regulators globally apply similar minimum capital standards for banks.

Need for Basel Norms:

• Banks lend to various borrowers, each carrying its own risk.
• Banks utilize public deposits and market-raised funds (equity and debt), exposing them to default risks.
• Basel norms are designed to mitigate these risks by requiring banks to maintain a certain percentage of capital as security.

Why Basel:

• Basel is a city in Switzerland, home to the Bank for International Settlements (BIS).
• BIS fosters cooperation among central banks toward financial stability and common banking regulation standards.
• Founded in 1930.

Types of Basel Norms:

Basel-I:

• Introduced in 1988, focused mainly on credit risk.
• Defined capital and risk weights for assets; set minimum capital requirement at 8% of risk-weighted assets (RWA).
• Example: Assets backed by collateral had lower risk weights than unsecured personal loans.
• India adopted Basel-I guidelines in 1999.

Basel-II:

• Published in 2004, these were refined versions of Basel I.
• Based on three pillars:
• Capital Adequacy Requirements (minimum 8% of risk assets).
• Supervisory Review (better risk management for credit, market, and operational risks).
• Market Discipline (increased disclosure requirements).
• Basel II norms are yet to be fully implemented in India and overseas.

Basel-III:

• Released in 2010 after the 2008 financial crisis.
• Aims to promote a resilient banking system focusing on four parameters:
• Capital:
• Capital Adequacy Ratio to be maintained at 12.9%.
• Minimum Tier 1 and Tier 2 capital ratios of 10.5% and 2% of risk-weighted assets respectively.
• Leverage:
• Leverage ratio at least 3% (ratio of tier-1 capital to average total assets).
• Funding and Liquidity:
• Liquidity Coverage Ratio (LCR): Banks to hold a buffer of high-quality liquid assets for 30-day stress scenarios.
• Net Stable Funding Ratio (NSFR): Banks to maintain stable funding for off-balance-sheet assets over a one-year horizon.

Basel norms are crucial for ensuring the stability and resilience of the international banking system. They require banks to maintain adequate capital, manage risks effectively, and enhance transparency through disclosures. The ongoing evolution from Basel-I to Basel-II and Basel-III reflects the continuous efforts to address the complexities and challenges in the banking sector.