Regulatory Compliance

Basel III

Basel II - 315px

What is Basel III?

The Basel III framework is a central element of the Basel Committee for Banking Supervision (BCBS)’s response to the Global Financial Crisis (GFC). The Basel III measures seek to promote regulation, supervision and risk management across the global banking sector.

Basel III aims to improve the global banking sector’s ability to cope with financial stress, improve risk management and increase transparency. Written in the wake of the 2008 GFC, Basel III seeks to implement tighter rules that will mitigate or prevent another crisis.

It builds upon its two predecessors: Basel I and Basel II. It was first introduced in 2009 before compliance enforcements began in 2013. Since then, banks have been slowly phased into Basel III. Within Europe, Capital Requirements Directives (CRD) IV was implemented to strengthen the regulations of the banking sector by using Basel III as a basis. There is a strong overlap between the EU’s proposals on CRD IV and the rules set out under Basel III.


How Basel III affects clients

Basel III regulations are far-reaching and while the framework is global, the implementation is carried out on a regional and national basis. Some of these new implications are:

Higher capital ratios
The previous Basel regulations split capital into two categories: Tier 1 and Tier 2. Tier 1 refers to common stock and preferred stock like common stock. Tier 2 refers to preferred stock like debt, subordinated debt and accounting reserves like debt. Of the two, banks typically hold more Tier 2 capital, therefore Basel III capital requirements focus on Tier 1 capital.

Banks will now be required to fund 4.5% of risk-weighted assets themselves through common equity. This is a 2.5% increase from the previous requirement set in place by Basel II. Minimum Tier 1 capital has also been increased to 6%, from 4%.

In addition to these new requirements, Basel III states that softer forms of capital, such as subordinated debt, will no longer count as capital for Tier 1 or Tier 2. This is to prevent reliance on unusable capital instruments during financial turmoil.

Leverage ratio and liquidity safety measures
In this scenario, leverage ratio refers to Tier 1 capital divided by all assets without risk-weighting. During the GFC, many banks with high leverage ratios became insolvent and had to be bailed out. This was due to the massive fall of asset value. Thus, BCBS decided to regulate leverage ratios by implementing a minimum requirement of 3%.

New requirements for liquidity ratios come in two parts. First, the Liquidity Coverage Ratio (LCR) is the ratio of high-quality liquid asset to cash outflows for a minimum of 30 days. Banks need to have at least 100% coverage. Second, the Net Stable Funding Ratio (NSFR) is the ratio of liquidity to the liabilities that mature in a year, maximum. It is the long-term version of the LCR. This means that banks must have enough funds to last for a year in the case of an emergency.

Countercyclical measures
During times of credit expansion, Basel III requires banks to hold onto additional capital and add to long-term reserves. In contrast, during times of credit contraction, these requirements will be lowered. This will allow for a little bit of cushion room and encourage lending during financial stress.

How can DTCC help?

Basel III has brought increased complexity to collateral management, leading firms to seek new ways to manage their balance sheet more efficiently and to effectively comply with upcoming rules.

A firm can be the sole guarantor or part of a syndicate of guarantors behind a commercial paper program. The guarantor(s) must hold 100% of the amount for any commercial paper that is maturing within 30 days in High Quality Liquid Assets (HQLA) as collateral under a portion of the Basel III regulations.

But what about instances where the entire amount of the commercial paper is not issued? Or the amounts of an issue that mature in more than 30 days? For example, if an issuing company has a program that can issue up to $1 billion in commercial paper but issues only $800 million, the guarantor(s) without knowledge of the actual outstanding being only $800 million, must set-aside $1 billion. The value proposition to the guarantor is that it provides a true short-term liquidity number.

DTCC’s Liquidity Coverage Ratio (LCR) Data Service facilitates market participants’ collateral requirement by creating calculations about firms’ commercial paper portfolio exposure to subsequently provide maturity time horizons, thereby helping them allocate capital more efficiently. The commercial paper market activity settled through the Depository Trust Company (DTC) allows the LCR Data service to aggregate industry data with outstanding depth and breadth. Each business day commercial paper issuers and paying agents send to DTC approximately $100 billion in new issuances.

FRTB real-price observations data
The Fundamental Review of the Trading Book (FRTB) released by the BCBS in 2016 overhauls the minimum capital requirements for market risk to address shortcomings of the current Basel III market risk capital framework. DTCC is positioned to deliver an FRTB “real” price observation data service that will assist the industry with demonstrating the modellability of risk factors, leveraging the existing data collection and processing infrastructure already used by DTCC to support global post-trade activity.

Industry-owned and -governed, DTCC has partnered closely with market participants and industry organizations to provide input and guidance in the development of the solution.

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