Basel III

Common Equity Tier 1 (CET1) capital requirements

${\displaystyle {\frac {\mbox{CET1}}{\mbox{RWAs}}}={\mbox{CET1}}\;{\textrm {ratio}}}$

Basel III requires banks to have a minimum CET1 ratio (Common Tier 1 capital divided by risk-weighted assets (RWAs)) at all times of:

• 4.5%

Plus:

• A mandatory "capital conservation buffer" or "stress capital buffer requirement", equivalent to at least 2.5% of risk-weighted assets, but could be higher based on results from stress tests, as determined by national regulators.

Plus:

• If necessary, as determined by national regulators, a "counter-cyclical buffer" of up to an additional 2.5% of RWA as capital during periods of high credit growth. This must be met by CET1 capital.

In the U.S., an additional 1% is required for globally systemically important financial institutions.

It also requires minimum Tier 1 capital of 6% at all times.

Common Tier 1 capital comprises shareholders equity (including audited profits), less deductions of accounting reserve that are not believed to be loss absorbing "today", including goodwill and other intangible assets. To prevent the potential of double-counting of capital across the economy, bank's holdings of other bank shares are also deducted.

Tier 2 capital requirements

Tier 2 capital + Tier 1 capital is required to be above 8%.

Leverage ratio requirements

Leverage ratio is calculated by dividing Tier 1 capital by the bank's leverage exposure. The leverage exposure is the sum of the exposures of all on-balance sheet assets, 'add-ons' for derivative exposures and securities financing transactions (SFTs), and credit conversion factors for off-balance sheet items.

Basel III introduced a minimum leverage ratio of 3%.

${\displaystyle {\frac {\mbox{Tier 1 Capital}}{\mbox{Total exposure}}}\geq 3\%}$

The U.S. established another ratio, the supplemental leverage ratio, defined as Tier 1 capital divided by total assets. It is required to be above 3.0%. A minimum leverage ratio of 5% is required for large banks and systemically important financial institutions. In the EU, the minimum bank leverage ratio is the same 3% as required by Basel III. The UK requires a minimum leverage ratio, for banks with deposits greater than £50 billion, of 3.25%. This higher minimum reflects the PRA's differing treatment of the leverage ratio, which excludes central bank reserves in 'Total exposure' of the calculation.

Liquidity requirements

Basel III introduced two required liquidity/funding ratios.

Counterparty risk: CCPs and SA-CCR

The standardised approach for counterparty credit risk (SA-CCR) replaced the current exposure method. SA-CCR is used to measure the exposure at default of derivative transactions and in the leverage exposure measure and non-modelled Risk Weighted Asset calculations, with potential exposure to central counterparty clearing default.

Capital requirements for equity investments in funds

The framework requires banks to take account of an investment fund's leverage when determining risk-based capital requirements associated with the investment and more appropriately reflecting the risk of the fund's underlying investments, including the use of a 1,250% risk weight for situations in which there is not sufficient transparency.

Limiting large exposure to external and internal counterparties

The Large Exposures Framework (LEX) restricts a financial institution's maximum loss from any single counterparty failure to 25% of its Tier 1 capital. Exposures between Global systemically important financial institution have a stricter limit of 15% of Tier 1 capital. An exposure is defined as a "large exposure" if it reaches or exceeds 10% of the bank's eligible capital base.

Capital standards for securitisations

A revised securitisation framework, effective in 2018, aims to address shortcomings in the Basel II securitisation framework and to strengthen the capital standards for securitisations held on bank balance sheets. The frameworks addresses the calculation of minimum capital needs for securitisation exposures.

Basel III reclassifies physical gold from a Tier 3 asset to a Tier 1 asset.

Interest rate risk in the banking book

New standards for "interest rate risk in the banking book" (IRRBB) became effective in 2023. Banks are required to calculate their exposures based on "economic value of equity" (EVE) and "net interest income" (NII) under a set of prescribed interest rate shock scenarios. The standards thereby deal with the risks associated with a change in interest rates, including interest rate gaps, basis risk, yield curve risk, and option risk.

The bank's exposure to IRRBB is then equal to the largest negative change in EVE across all scenarios - in essence, the theoretical risk to the economic value of a bank's equity from a change in interest rates.

IRRBB falls under Pillar II.

Basel III: Finalising post-crisis reforms

The Basel III: Finalising post-crisis reforms standards cover further reforms in six areas:

• a revised standardised approach for credit risk (SA-CR), which will improve the robustness and risk sensitivity of the existing approach;
• revisions to the internal ratings based approach (IRB) for credit risk, where the use of the most advanced internally modelled approaches for low-default portfolios will be limited;
• revisions to the Credit valuation adjustment risk (the process through which counterparty credit is valued, priced and hedged - using a standardised approach), including the removal of the internally modelled approach and the introduction of a revised standardised approach;
• a revised standardised approach for Operational risk, which will replace the existing standardised approaches and the advanced measurement approaches; based on income and historical losses of the bank
• an aggregate output floor, which will ensure that banks' risk-weighted assets (RWAs) generated by internal models are no lower than 72.5% of RWAs as calculated by the Basel III framework's standardised approaches. Banks are also be required to disclose their RWAs based on these standardised approaches. Replaces Basel II output floor with a more robust risk-sensitive floor and disclosure requirements;
• revisions to the measurement of the leverage ratio and a leverage ratio buffer for global systemically important financial institutions (G-SIBs), which will take the form of a Tier 1 capital buffer set at 50% of a G-SIB's risk-weighted capital buffer; definitions and requirements, exposure measures for on-balance sheet exposures, derivatives, securities financing transactions and off-balance sheet items.

The reforms revise the standardised approach for credit risk (SA-CR), the internal ratings-based approach for credit risk (IRB), the credit valuation adjustment (CVA) framework, the calculation of operational risk RWAs, the leverage ratio, and introduce an aggregate output floor for risk weighted assets (RWAs).

Fundamental Review of the Trading Book

The Fundamental Review of the Trading Book set minimum capital requirements for market risk in the trading book based on a better calibrated standardised approach or internal model approval (IMA) for an expected shortfall measure rather than, under Basel II, value at risk.

The FRTB revisions address deficiencies relating to the prior Standardized approach and Internal models approach and particularly revisit the following:

• The boundary between the "trading book" and the "banking book": i.e. assets intended for active trading; as opposed to assets expected to be held to maturity, usually customer loans, and deposits from retail and corporate customers; important since the vast majority of losses were from trading books during the 2008 financial crisis.
• The use of expected shortfall instead of value at risk as a risk measure under stress; thus ensuring that banks capture tail risk events
• The risk of lack of market liquidity

FRTB additionally sets a "higher bar" for banks to use their own, internal models for calculating capital, as opposed to the standardised approach. Here, for a trading desk to qualify for the internal models approach, its model must pass two tests: a profit and loss attribution test and a backtest.