Basel III (or the Third Basel Accord) is a global, voluntary regulatory standard on bank capital adequacy, stress testing and market liquidity risk.
The Basel Accords were developed in response to the deficiencies in financial regulation that the financial crisis revealed in 2007-08. Basel III is designed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.The Liquidity Cash Ratio requirements of the Third Basel Accord came into effect on 1 January 2015. Although the Basel standards are voluntary, national regulators have adopted them widely and financial institutions are responding.
Basel II was focussed on capital requirements, assuming that lending has risks and that capital needs to be set aside. Basel III has increased these capital requirements, but in addition has stated detailed requirements on leverage and liquidity. Under Basel III, banks will need to meet specific liquidity targets as set out in the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
NSFR measures the amount of stable funding held against the stable funding requirement. In this instance, stable funding is defined as the proportion of assets that are funded by long-term, stable funding such as inter-bank lending and equity. The purpose of this is to promote resilience over a longer-term horizon.
Specific NSFR targets have not yet been published, and will not become a minimum standard until 1 January 2018, but in the interim, the following progressive LCR targets have been published.
LCR is a measure of whether a bank has enough High Quality Liquid Assets (HQLA) to survive a 30-day stress test. An asset qualifies for HQLA where it can be traded in a market with enough participants that the asset can be sold without materially affecting the market rate. The purpose is to reduce the risk of liquidity shortages seen during the financial crisis.
The Basel III stress test is designed to drive banks towards adopting a more cautious approach by imitating a systemic crisis in the banking sector. During the 30-day period a number of assumptions are made around the withdrawal of deposits and the paying back of loans.
- Withdrawal of deposits – defined by the type of investor.
- Upon repayment of a loan, 50 per cent of the loan value will not be repaid.
- Contractual outflows resulting from a downgrade in the credit rating of the institution that is being tested.
- Increased market volatility causing increased collateral requirements.
- Drawdown of unused credit facilities that the institution has issued to its clients.
One of the interesting factors in these tests is the considerable difference in percentage withdrawal of deposits dependent on investor type. For example, a corporate with a simple relationship to the bank is assumed to withdraw 75 per cent of its deposits, whereas a corporate with an operational relationship is assumed to withdraw only 25 per cent. This is a clear example of Basel III creating increased connectivity within the sector, to encourage banks to offer a variety of services to their clients to increase ‘stickiness’.
Under these conditions LCR is defined as:
LCR = Stock of HQLA/Total net cash outflows over the next 30 calendar days
The calculation and monitoring of cash and other liquid assets is a significant challenge for most banks and has generated a lot of activity in preparation for the deadlines. Even without the introduction of NSFR requirements the journey from 60 to 100 per cent LCR over a period of four years will have a significant impact on Return On Equity (ROE) and overall performance.