The Key Regulatory Changes in Basel III Endgame Banks Need to Know

The Key Regulatory Changes in Basel III Endgame Banks Need to Know

[Source - Bloomberg ]

A stabilized banking system is a topic paid less heed to. The thought of instability in the banking system doesn’t even cross our minds as much. To ensure financial stability banks have laid down some regulations in determining their capital flow worldwide. Banks also appoint financial regulators worldwide to impose minimum capital requirements. Basel III Endgame plays a comprehensive role that lays the foundation of a set of rules developed by the Basel Committee after the financial instability in 2007- 09.

Basel III Endgame, also known as the Third Basel Accord, focuses on the amount of capital banks must possess against credit, market, and operational risks. It is a prolonged effort to empower an international banking groundwork that began in 1975. Basel I and Basel II were established to enhance the banking fraternity’s ability to function stably under financial strain, promote transparency, and manage risk.

During the uncalled-for period of banking in 2007-08, the approaches of Basel II already looked outdated or unpractical to the then-current happenings. The significant shift from Basel II to Basel III passed on a positive message of managed risk in banking to the general public. As of now, many parts of Basel III Endgame have been in existence globally. However, due to the pandemic banks need some time to adjust to the new operative scenarios. The newer version includes modernizations on how banks scrutinize the risk of people defaulting on loans, how to internally manage the reserve stock of money in anticipation of a crisis, & how to handle fraud or system failures.

Key Regulatory changes in Basel III endgame

The global banking ruckus in 2023 reinjected the importance of an administrative framework functioning efficiently during a crisis. As uninformed banking failure can cause immense disruption, banks do not have enough bandwidth to come up with decisiveness as needed. An efficient regulatory framework protects the interests of depositors & limits risks associated with financial instability in cases of turmoil.

a. Streamline the framework:

This can be done by replacing AT1 with other existing more reliable forms of capital (Tier 1 & Common Equity Tier 1 (CET 1)). This would be an extensive move for structural change & would require careful consideration & transition. The CET 1 is a component of Tier 1 Capital, and it encompasses ordinary shares and retained earnings. One of the main regulations introduced in the Basel III was putting a limit to the type of capital that banks could hold in their capital structure.

b. Maintain the status quo:

Not implementing the said changes helps AT1 with other existing and more reliable forms of capital (Tier 2 & Common Equity Tier 1 (CET 1)). This would be a significant change as it has the potential to create an investor base & implement the simpler third path.

c. Effective capital framework:

Large-scale banks that are active globally, are able to replace 1.5 % with AT1 with 1.25 %. This enhanced capital effectiveness in crises with fewer uncertain situations in its operation that could undermine confidence & obstruct recovery or resolution. The cost of compliances also diminishes as the framework is simplified & has replaced an instrument in AT1 which is bound to additional marketing, issuing & design.

d. Liquidity requirements:

The Liquidity Coverage Ratio (LCR) studies a bank’s liquidity risk profile. Banks have an adequate stock of unfettered high-quality liquid assets that can be easily & immediately converted into financial markets. However, the Net Stable Funding Ratio’s (NSFR) goal is to diminish the probability that shocks affecting a bank’s usual funding sources. This ratio measures a bank’s medium & long-term resilience.

Pillars for Banks: Basel III Endgame

The basel norms are based on 3 basic requirements: minimum capital stock, which enhances the quality & quantity functioning of the bank, the supervisory review process, and minimum capital requirements combined with market discipline. It aims to strengthen transparency & disclosures that promote market discipline. Here are some more points on significance:

Pillar 1: Minimum capital requirements:

Pillar 1 compels banks to keep a minimum capital adequacy of 8%. However, the Basel III norms also need banks to preserve much extra capital buffering. It consists of a countercyclical capital buffer & a capital conservation buffer.

Pillar 2: Supervisory review process:

The second pillar orders banks to have a streamlined process to identify, manage, & assess the obstacles they are about to face. The whole process is thoroughly supervised by the bank supervisor.

Pillar 3: Market discipline:

This pillar requires the bank to uncover the data about their capital stocks & risk management practices. As this information is used by investors & other stakeholders to assess the risk involved in the investment.

Prospective Effects of Basel III Endgame

Basel III endgame has emerged as a game changer that enhances a safer banking system while obstructing future economic growth very minimally. Its impact is likely to be different for different people like stakeholders or investors. It is predicted by financial experts that it will make stock market investments a lot safer & bond investors will also enjoy some security in their investment projects. A deeper understanding will enable the bind investors to gain insights about the financial sector moving forward. It will provide guidance in terms of crafting macroeconomic opinions on the stability of the global financial system && the world economy.

Key Principles of Basel III Endgame

Some key principles are as follows:

a. Minimum capital requirements:

The Basel III Endgame buzz increased the minimum Basel III capital requirements for banks from 2% to Basel II to 4.5% of common equity, as a percentage of the bank’s risk-weighted assets. There is also an extra 2.5% buffer capital investment that brings the total minimum requirement to 7% to be Basel compliant. Banks can use the buffer when they face financial issues, but using this buffer can lead to an increase in financial constraints when paying dividends.

b. Leverage ratio:

Basel III Endgame introduced a non-risk-based leverage ratio as a backstop to the risk-based capital requirements. Banks are required to hold a leverage Basel III leverage ratio excess of 3%, & the non-risk-based leverage ratio is calculated by dividing Tier 1 capital by the average total consolidated assets of a bank.

c. Liquidity requirements:

Basel III Endgame introduced the use of two liquidity ratios, including the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The LCR mandates that banks hold sufficient highly liquid assets that can withstand a 30-day stressed funding scenario, specified by the supervisors. The Basel III liquidity requirements abided by the mandate in 2015.

Conclusion

Complying with Basel III, & the Basel Committee on Banking Supervision (BCBS) rule 239 ‘Principles for effective risk data aggregation and risk reporting’ creates a profound data management challenge for Global Systematically Important Banks & Domestically Systematically Important Banks alike. Basel III Endgame has more & better quality of risk data. Banks need to be proactive & revert from systems within hours rather than days or longer to avoid risk from the data.

Uncover the latest trends and insights with our articles on Visionary Vogues