What is Basel III, why it is important?

The Basel III rule introduced several measures to strengthen the capital requirement of banks across the globe and presented more capital buffers to supplement the risk-based minimum capital requirements. This is to ensure that adequate funding is maintained in case there are other severe banking crises.The Reserve Bank of India introduced Basel III norms in India in 2003 and aims to bring in all commercial banks by March 2019. In India, lenders have to adhere to these regulations by March 2019.

Compared to Basel II frame work, 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).
The Basel III rule introduced the following measures to strengthen the capital requirement and introduced more capital buffers. The capital norms recommend Capital Adequacy ratio (CAR) be increased to 8 per cent internationally, while in India it is 9 per cent. CAR is a ratio of a bank’s capital to its risk. Out of the 9 per cent of CAR, 7 per cent has to be met by Tier 1 capital while the remaining 2 per cent by Tier 2 capital. So, if the bank has risky assets worth Rs.100, it needs to have Tier 1 capital worth Rs.7/-. This capital can be easily used to raise funds in times of troubles.

Creation of capital buffer: In addition, banks also have to hold an additional buffer of 2.5 per cent of risky assets known as Capital Conservation Buffer which is designed to absorb losses during periods of financial and economic stress. The capital conservation buffer must be met exclusively with common equity. Financial institutions that do not maintain the capital conservation buffer faces restrictions on payouts of dividends, share buybacks, and bonuses. In addition to the above,

Countercyclical buffers: 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 Countercyclical Capital Buffer is  within a range of 0% and 2.5% of common equity or other fully loss absorbing capital  which may be implemented according to national circumstances. This buffer serves as an extension to the capital conservation buffer.

Leverage ratio: The leverage ratio is calculated by dividing Tier 1 capital by the bank’s average total consolidated assets; the banks were expected to maintain a leverage ratio in excess of 3% under Basel III. The new leverage ratio is a non-risk-based measure to supplement the risk-based minimum capital requirements. This is to ensure that adequate funding is maintained in case there are other severe banking crises.

Liquidity Coverage Ratio: The liquidity coverage ratio (LCR) signifies 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.

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