The Basel Committee finalises the Basel III agreements

On 7 December, after several years of negotiations (starting in 2012 with the market risk review), Mario Draghi, chair of the Basel Committee’s Group of Governors and Head of Supervision (G-HOS), announced the finalisation of the Basel III agreements. These represent the final stage in the post-financial crisis reforms to the prudential regulations.

For the record, the original Basel III agreements, published in December 2010, primarily aimed at addressing the shortcomings identified during the financial crisis by establishing a higher and better-quality capital basis for banks through a stricter definition of the elements eligible in regulatory capital and an increase in capital requirements. They also introduced rules to control liquidity risk and excessive leverage risk. The Basel Committee decided that all aspects of these approaches were in need of review.

Contents of the package and implementation period

The published text introduces the following reforms:

• a new standard approach to credit risk;
• a revision of the application scope of the IRB approach to credit risk;
• new regulatory approaches for the calculation of the prudential CVA;
• a new, single standardised approach to operational risk;
• an additional leverage ratio requirement for systemically important banks;
• a capital “output floor” calibrated at 72.5% of the new standardised approaches.

To enable banks to prepare, the Committee has provided for a lengthy implementation period, with application of these new provisions no later than 1 January 2022, while the output floor will not be fully introduced until 2027, following a five-year phase-in period. For the market risk framework (not included in this package), the Committee refers to the standard published in January 2016. Discussions are still in progress concerning the application of some its provisions. It has also been agreed that this standard (also known as the FRTB) will not be effective until 2022, rather than 2019 as initially planned.

Impact of the reform

The Basel Committee and the EBA have both published impact studies on these reforms, based on the data issued by the banks at 31 December 2015. For European banks, the overall rise in capital requirements will be 12.9%, accompanied by a reduction of 0.6% in the CET1 ratio. Some banks may be more affected than others. The G20’s call for no further significant increase in overall capital requirements has therefore only been partially respected, since it was generally accepted that a ‘non-significant’ increase would not exceed 5%. However, the Committee believes that the banks will be able to meet this requirement without large capital issues by setting aside profits to the reserves throughout the implementation phase.

European implementation

A revision of the CRR-CRD has been under discussion at the European level since late 2016, but this has focused on the implementation of previously-adopted international reforms (e.g. the TLAC, the NSFR, large exposures, etc.).

The European Commission has announced that it intends to implement these final Basel III reforms, but with due regard for local circumstances, and that it will consult the industry, Member States and other stakeholders before conducting an in-depth impact assessment. Any legislative proposal for implementation would be independent of the CRR-CRD amendments currently under review, and would repeal or supplement existing provisions.

The main changes

Credit risk

A new standard approach to credit risk which includes the existing exposure categories: retail, real estate, banks, corporates including specialised lenders, sovereign exposures and covered bonds (new), but with new weightings or under new conditions. In contrast to the original objective of the Basel Committee, the new approach still relies on external ratings; however, banks should conduct due diligence in order to ensure that these ratings reflect counterparty solvency in a conservative and appropriate manner. Otherwise, they must apply at least the risk weight of the higher credit quality step.

• Sovereign exposures: no change with respect to the existing regulations.
• Regulatory retail exposures: this category will continue to receive a weight of 75% but only under certain conditions; otherwise a weight of 100% will apply.
• Real estate exposure: the current 35% weighting will be replaced by a series of weightings (between 20% and 150%) of residential loans depending on the borrower’s loan-to-value (LTV) level. The text also states that guaranteed loans meeting certain criteria may be treated in the same way and not as secured loans.
• Bank exposures: the weight will be based on the external credit risk assessment (ECRA approach, between 20% and 150%) for banks incorporated in jurisdictions that allow the use of external ratings, or the standardised credit risk assessment (SCRA approach, between 30% and 150%) if the jurisdiction does not allow external ratings to be used. This last approach is based on assigning a rating of A, B or C to the borrowing bank, reflecting its respect for the minimum regulatory requirements.
• Corporate exposures: similarly, weighting depends on whether external ratings can be used (ECRA: between 20% and 150%, or 100% if not rated); otherwise the SCRA approach is applied, with a default risk weight of 100%. However, corporates that the bank identifies as “investment grade” may be weighted at 65%.
• Special case of SMEs: SMEs may be risk weighted at 85%, or 75% in the case of retail SME exposures.
• Special case of specialised lending exposures: exposures to product finance, object finance or commodities finance (typically financed through an SPV) will be weighted at 100% with the exception of project finance, which will be risk-weighted at 130% during the pre-operational phase and 100% during the operational phase, or 80% if it is deemed to be high quality.
• Equity exposures: risk-weighted at 250% (or 400% for the most speculative holdings), with national discretion to assign a risk weight of 100% to equity holdings in national programmes.
• Exposures to covered bonds: will be weighted on the basis of the external rating of the bond, if rated, or of the issuing bank otherwise.
• Off-balance sheet exposures: application of new credit conversion factors (CCF) of between 10% and 100% before risk-weighting on the basis of the borrower.

The internal ratings-based approach (IRB) subject to supervisory approval will in future be limited to corporate exposures (including the five sub-classes of specialised lending), retail (divided into three exposure sub-classes), banks and sovereign exposures. In accordance with the following criteria:

Further reforms

• CVA risk: initially introduced in the first Basel III agreement, the Committee has now enhanced the robustness, risk sensitivity and consistency of the CVA framework. In contrast, because of the complexity of estimating such risks, the Committee has eliminated the advanced approach (A-CVA) and in future will only permit the use of the new standardised approach with supervisory approval (SA-CVA, derived from the market risks approach) or the basic method (B-CVA).
• Operational risk: the framework has been simplified, the existing approaches (two standard and once advanced) being replaced by a single standardised approach. The capital requirement will be calculated by determining a business indicator component affected by a coefficient (12, 15 or 18%) depending on the level of the indicator, which is then multiplied by an indicator reflecting the bank’s operational losses in recent years (ILM, the internal loss multiplier). Note that the supervisor will have the discretion not to apply the ILM to all the banks under its responsibility, or exceptionally to authorise banks to exclude certain operational losses from the calculation of the ILM.
• Leverage ratio: the committee confirms the calibration of a 3% leverage ratio minimum requirement for all banks, and introduces an additional requirement for global systemically important banks (G-SIBs) corresponding to 50% of the systemic buffer assigned to the bank for the calculation of its solvency ratio. Further, G-SIBs will face capital distribution constraints where their leverage and/or CET1 ratios stand at certain levels.
• Output floor: in order to determiner this minimum capital level to be respected, banks will have to apply the maximum of (i) the total requirement calculated using both standardised and internally-modelled approaches (where applicable) and (ii) 72.5% of the total calculated using only the standardised approaches (credit, counterparty, CVA, securitisation, market, operational).

The adoption of this text marks an important stage in the finalisation of the minimum requirements that apply to the banks (Pillar 1). The Committee will now turn its attention to the enhancement of Pillar 2, and has just published a consultative document on stress testing principles.

For more information: Basel III: Finalising post-crisis reforms