BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed

upon by the members of the Basel Committee on Banking Supervision in 2010-11.[1] This, the third of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. For instance, the change in the calculation of loan risk in Basel II which some consider a causal factor in the credit bubble prior to the 2007-8 collapse: in Basel II one of the principal factors of financial risk management was out-sourced to companies that were not subject to supervision: credit rating agencies. Ratings of creditworthiness and of bonds, financial bundles and various other financial instruments were conducted without supervision by official agencies, leading to AAA ratings on mortgage-backed securities, credit default swaps and other instruments that proved in practice to be extremely bad credit risks. In Basel III a more formal scenario analysis is applied (three official scenarios from regulators, with ratings agencies and firms urged to apply more extreme ones). The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.[2][3]. Outside the banking industry itself, criticism was muted. Bank directors would be required to know market liquidity conditions for major asset holdings, to strengthen accountability for any major losses.

Overview Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of riskweighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the

available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.[4]

Summary of proposed changes

First, the quality, consistency, and transparency of the capital base will be raised. o Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained earnings o Tier 2 capital instruments will be harmonized [5] o Tier 3 capital will be eliminated. Second, the risk coverage of the capital framework will be strengthened. o Promote more integrated management of market and counterparty credit risk o Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit rating o Strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repo and securities financing transactions o Raise the capital buffers backing these exposures o Reduce pro-cyclicality and o Provide additional incentives to move OTC derivative contracts to central counterparties (probably clearing houses) o Provide incentives to strengthen the risk management of counterparty credit exposures o Raise counterparty credit risk management standards by including wrong-way risk Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework. o The Committee therefore is introducing a leverage ratio requirement that is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sector Introduce additional safeguards against model risk and measurement error by supplementing the risk based measure with a simpler measure that is based on gross exposures. Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be

drawn upon in periods of stress ("Reducing pro-cyclicality and promoting countercyclical buffers"). o The Committee is introducing a series of measures to address pro-cyclicality: Dampen any excess cyclicality of the minimum capital requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the banking sector that can be used in stress; and o Achieve the broader macro prudential goal of protecting the banking sector from periods of excess credit growth. Requirement to use long term data horizons to estimate probabilities of default, downturn loss-given-default estimates, recommended in Basel II, to become mandatory Improved calibration of the risk functions, which convert loss estimates into regulatory capital requirements. Banks must conduct stress tests that include widening credit spreads in recessionary scenarios. o Promoting stronger provisioning practices (forward looking provisioning): Advocating a change in the accounting standards towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).[6] Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the oversight panel of the Basel Committee on Banking Supervision issued a statement saying that regulators will allow banks to dip below their required liquidity levels, the liquidity coverage ratio, during periods of stress.[7]) The Committee also is reviewing the need for additional capital, liquidity or other supervisory measures to reduce the externalities created by systemically important institutions.

Macroeconomic Impact of Basel III Basel III is an opportunity as well as a challenge for banks. It can provide a solid foundation for the next developments in the banking sector, and it can ensure that past excesses are avoided. Basel III is changing the way that banks address the management of risk and finance. The new regime seeks much greater integration of the finance and risk management functions. This will probably drive the convergence of the responsibilities of CFOs and CROs in delivering the strategic objectives of the business. However, the adoption of a more rigorous regulatory stance might be hampered by a reliance on multiple data silos and by a separation of powers between those who are responsible for finance and those who manage risk. The new emphasis on risk management that is inherent in Basel III requires the introduction or evolution of a risk management framework that is as robust as the existing finance management infrastructures. As well as being a regulatory regime, Basel III in many ways provides a framework for true enterprise risk management, which involves covering all risks to the business.[9]