Basel III builds upon the foundation of Basel II by introducing stricter capital requirements, liquidity standards, and a leverage ratio to enhance the resilience of the global banking system. While Basel II focused on risk-based capital requirements, Basel III expands on this by adding liquidity standards and a non-risk-based leverage ratio to prevent excessive risk-taking and ensure banks can withstand financial shocks.The key difference between the Basel II and Basel III are that in comparison to Basel II framework, the Basel III framework prescribes more of common equity, creation of capital buffer, introduction of Leverage Ratio, Introduction of Liquidity coverage Ratio(LCR) and Net Stable Funding Ratio (NSFR).
Leverage Ratio: The leverage ratio is calculated by dividing Tier 1 capital by the bank’s average total consolidated assets (sum of the exposures of all assets and non-balance sheet items). The banks are expected to maintain a leverage ratio in excess of 3% under Basel III.
Liquidity Coverage Ratio: The liquidity coverage ratio (LCR) denotes to highly liquid assets held by financial institutions to meet short-term obligations. The ratio is a generic stress test that aims to anticipate market-wide shocks. The LCR is a requirement under Basel III for a bank to hold high-quality liquid assets (HQLAs) sufficient to cover 100% of its stressed net cash requirements over 30 days. The LCR is calculated as: LCR = HQLAs / Net cash outflows.
Net stable funding (NSF): The net stable funding is to ensure that banks maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities.
Creation of capital buffer: The creation of adequate capital buffer is a mechanism to build up additional capital during periods of excessive credit growth. The Basel Committee on Banking Supervision by promoting the creation of countercyclical buffers as set forth in the Basel III regulatory reforms to enable banks to absorb losses and continue lending in the subsequent downturn.
Counter cyclical buffer is another support system for Capital Conservation Buffer recommended by BASLE- III on the basis of weighted average of capital conservation buffer built up in earlier years
(The risk weighted asset (RWA) refer to the fund based assets such as cash, loans, investments and other assets but their value is assigned a risk weight and credit equivalent amount of all off-balance sheet activitis.The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of certain assets to establish their risk coefficients).
The Basel III framework also prescribes higher ratio in respect of minimum ratio of total capital to RWAs, Minimum Ratio of common equity to RWAs ,Tier I capital to RWAs , Core tier 1 Capital RWAs ,Capital Conservation Buffers to RWAs,Countercyclical Buffer etc.which are as under.
a) Minimum Ratio of total capital to RWAs 8% under Basel II increased to 10.50%
b) Minimum Ratio of common equity to RWAs 2% under Basel II increased to (4.50% to 7.00%) under Basel III
c) Tier I capital to RWAs 4% under Basel IIto 6% under Basel III
d) Core tier 1 Capital RWAs 2% under Basel II to 5% under Basel III
e) Capital Conservation Buffers to RWAs none under Basel II increased to 2.50% under Basel IIIf) Leverage ratio under Basel IIfrom none to 3.00% under Basel III
g) Countercyclical Buffer from none under Basel II to (0% to 2.50%) under Basel III
The risk weighted asset (RWA) refer to the fund based assets such as cash, loans, investments and other assets but their value is assigned a risk weight and credit equivalent amount of all off-balance sheet activitis.
Furthermore, in view of Basel III norms, RBI has modified the following existing Basel II framework, which includes the modifications and enhancements announced by BCBS in July 2009. RBI made amendments to, Basel II guidelines in respect of definition of Capital, Risk Coverage, Capital Charge for Credit Risk, External Credit Assessments, Credit Risk Mitigation and Capital Charge for Market Risk. Supervisory Review and Evaluation Process under Pillar 2, is also being modified.
Basel II vs Basel III: A Comparative Overview
Basel II: Overview
Focus:
Basel II aimed to refine the risk sensitivity of capital requirements by extending regulation beyond credit risk to include market and operational risks.
Key Components:
- Minimum Capital Requirement: 8% of risk-weighted assets (RWAs).
- Three Pillars Framework:
- Pillar 1 – Minimum Capital Requirements: Addressing credit, market, and operational risks.
- Pillar 2 – Supervisory Review Process: Assessment of bank-specific risks and internal capital adequacy.
- Pillar 3 – Market Discipline: Promoting transparency through public disclosures.
Limitations:
- Did not adequately address liquidity risk or systemic risk.
- Proved insufficient during the 2008 global financial crisis, where many banks faced severe liquidity shortages and interconnectivity failures.
Basel III: Overview
Focus:
Basel III was introduced to strengthen the resilience of the global banking system by enhancing capital quality, improving liquidity, and controlling leverage.
Key Components:
- Higher Capital Requirements:
- Minimum 4.5% Common Equity Tier 1 (CET1).
- Capital Conservation Buffer of 2.5%.
- Total CET1 requirement: 7% of RWAs.
- Liquidity Standards:
- Liquidity Coverage Ratio (LCR): Ensures banks hold sufficient high-quality liquid assets to survive a 30-day stress scenario.
- Net Stable Funding Ratio (NSFR): Promotes long-term resilience by requiring a stable funding profile relative to the composition of assets.
- Leverage Ratio:
- Non-risk-based minimum leverage ratio of 3%, acting as a backstop to risk-based requirements.
- Systemic Risk Mitigation:
- Measures to limit exposure to systemically important financial institutions (SIFIs) and promote macroprudential oversight.
- Higher Quality Capital:
- Greater emphasis on common equity, considered the highest-quality capital component.
Implementation Timeline:
- Originally set to begin in 2013, Basel III’s full implementation has been deferred multiple times, with final deadlines extended to January 1, 2022 for full compliance.
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