What exactly does Basel III mean for financial institutions and their risk-management practices?
The 2008 financial crisis shone a spotlight on the liquidity risk inherent in the financial system and triggered enormous regulatory changes. The Bank for International Settlements (BIS) issued a series of initiatives, proposals and recommendations aimed at strengthening the capacity of banks to withstand shocks, increase the quality of their assets and add greater depth to risk management with a view to achieving greater transparency.
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Under Basel III, several measures were introduced in a gradual manner beginning on January 1, 2013, in order to increase the required capital levels:
- increase of several capital ratios (Tier 1 Common, Tier 1 Capital and Total Capital);
- addition of a contra-cyclical capital cushion: 0% to 2.5%;
- addition of a capital preservation cushion: 2.5%;
- addition of a cushion for banking institutions that present a significant rise to the financial system: 1% to 2.5%; and
- new restrictions pertaining to dividends, bonuses and share buybacks if the capital ratio is not higher than the required minimum.
Tier 1 Common consists primarily of common shares and retained earnings:
- Tier 3 instruments (short-term subordinated debt) are no longer accepted;
- Tier 1 instruments other than common shares; and
- Tier 2 instruments issued by an international bank must contain a clause that requires them to be cancelled or converted into common shares when a triggering event occurs, at the discretion of the competent authority.
The liquidity coverage ratio, which defines the level of liquidity required to withstand a 30-day stressed funding scenario, covers two asset levels:
- Level 1, which includes cash and certain sovereign issuer bonds, is given a factor of 100%; and
- Level 2, which extends to blue-chip corporate bonds, covered bonds and sovereign issuer bonds, receives a factor of 85%.
The net stable funding ratio, which defines the liquidity level required to face an extended shortfall based on a horizon of one year, is calculated by dividing the assets that must remain on the balance sheet even during a crisis period by the assets that cannot be monetized during an extended crisis.
Gérard Bérubé is a financial journalist and assistant news editor with Le Devoir. gberube@ledevoir.com