Summary of Basel-III
- Basel III introduces a simple, transparent, non-risk based regulatory Leverage Ratio to constrain leverage in the banking sector and supplement risk based capital ratio as a safeguard against model risk. The leverage ratio is calculated by dividing tier 1 capital with total exposure.
- To increase the quality and quantity of the capital base of the banks, Basel III has introduced the following measures:
- Tier 1 capital has been divided into two parts: Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1). Minimum Tier 1 capital requirement has been set at 6% out of which CET1 is 4.5% and AT1 is 1.5%. However, minimum capital requirement has been kept unchanged from Basel II.
- Definition of capital has been made stringent in the Guideline. In line with Basel III, Tier 3 capital has been eliminated. Revaluation reserve for fixed asset, securities and equities will be gradually eliminated. Elimination of revaluation reserve should draw due attention of the banking community.
- A buffer CET1 capital named Capital Conservation Buffer has been proposed @ 2.5% in addition to the minimum capital requirement. Restriction has been put in distribution of profit (cash dividend and discretionary bonuses to staff) until the buffer is developed.
- In addition, the banks are required to deduct goodwill and other intangible assets, deferred tax asset, shortfall in provision, defined benefit pension fund assets and liabilities, investment in shares of financial institutions (including bank, NBFI and insurance) in excess of 10% bank’s capital, investment in own share, gain on sale related to securitization transactions etc. from their capital.
- The Guidelines require higher capital requirement for claims that are past due for ‘60 days and more’, which was earlier required for past due for ‘90 days or more’ in the previous guideline.
- Basel III introduced liquidity standard as a complement to the capital standard. Basel III developed two minimum standards for liquidity which supplement BIS’s ‘Principles for Sound Liquidity Risk Management and Supervision’ published in 2008. These are Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The objective of LCR is to promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high quality liquid asset to survive a significant stress scenario lasting for one month. The objective of NSFR is to promote resilience over a time horizon of one year by requiring banks to fund the activities with more stable sources of funding.
- Disclosures on leverage ratio, liquidity ratio and remuneration are newly added in the Guideline.
We summarize some challenges that banks are likely to face during the implementation of Basel III:
- Capital requirement of the banks will increase owing to capital conservation buffer (CCB). In case of failure to maintain CCB, there will be restriction in distribution of profit in the form of cash dividend and discretionary bonuses to staff.
- Elimination of revaluation reserve will reduce the capital positions of some banks.
- Defined benefit pension fund liabilities may appear as sizeable one, especially for the aged banks who did not properly assessed the liability earlier in line with BAS 19. This item should get highest importance of the bankers.
- Deduction of investment in shares of financial institutions (including bank, NBFI and insurance) in excess of 10% bank’s capital will reduce the capital position of some banks. Such deduction can be managed relatively easily by reducing exposure to financial sector.
- Investment of bank in its own share through mutual funds is also subject to deduction from capital. Banks shall have to look through holdings of mutual fund securities to deduct exposures to own shares.
- Higher capital requirement for claims that are past due for ‘60 days and more’ instead of ‘90 days or more’ will increase capital requirement of banks to some extent.
- Banks have to develop methodology to determine their own “Run-off factors” and “Weight factors” for calculating LCR and NSFR.
- Disclosures on leverage ratio, liquidity ratio and remuneration are newly added in the Guideline. Disclosures on remuneration require special attention of the banks.
Major differences between Basel-II and Basel-III.
| Basel-II | Basel-III |
| Regulatory capital was categorized into three tiers: Tier 1, Tier 2, and Tier 3. | The total regulatory capital will consist of sum of the following categories: 1) Tier 1 Capital (going-concern capital) a) Common Equity Tier 1 b) Additional Tier 1 2) Tier 2 Capital (gone-concern capital) |
| Tier 1 Capital: Ø Paid up capital Ø Non-repayable share premium account Ø Statutory Reserve Ø General Reserve Ø Retained Earnings Ø Minority Interest in subsidiaries Ø Non-Cumulative irredeemable Preference Shares Ø Dividend Equalization Account | Tier 1 Capital: 1) Common Equity Tier-1 (CET-1) Capital: Ø Paid-up Capital Ø Non-repayable share premium account Ø Statutory reserve Ø General reserve Ø Retained earnings Ø Minority interest in subsidiaries. Ø Dividend equalization reserve Ø Actuarial gain/loss Ø Non-repatriable interest-free funds from HO 2) Additional Tier-1 (AT-1) Capital: Ø Non-cumulative irredeemable preference shares Ø Instruments issued by the banks that meet the qualifying criteria for AT1 |
| Revaluation reserve for fixed assets and securities up to 50% and Revaluation reserve for equity instrument up to 10% was consider as Tier-2 Capital in Basel-II Guidelines. | Revaluation reserve for fixed asset, securities and equities will be gradually eliminated. |
| Full amount of General Provision was included in Tier-2 Capital. | General provisions eligible for inclusion in Tier 2 will be limited to a maximum 1.25% of credit risk weighted assets. |
| Minimum Capital Requirement is 10% of Risk Weighted Asset (RWA). Minimum Tier-1 @50% of Required Capital | Minimum Capital Requirement is 10% of RWA. Minimum Tier 1 @6% of RWA and Minimum CET1 @4.5% of RWA |
| There was no Capital Conservation Buffer | Minimum Total Capital plus Capital Conservation Buffer is (10% + 2.5%) = 12.50% of RWA |
| In Basel-II, The banks were required to deduct goodwill and other intangible assets, deferred tax asset and shortfall in provision from their capital. | In Basel-III, the banks are required to deduct goodwill and other intangible assets, deferred tax asset, shortfall in provision, defined benefit pension fund assets and liabilities, investment in shares of financial institutions (including bank, NBFI and insurance) in excess of 10% bank’s capital, investment in own share, gain on sale related to securitization transactions etc. from their capital. |
| Tier 3 Capital: Consisting of short-term subordinated debt (maturity less than or equal to five years), solely for the purpose of meeting a proportion of the capital requirements For Market risk. | Tier 3 Capital: Abolished in Basel III |
| There was no Leverage Ratio in Basel-II. | Basel III introduces a simple, transparent, non-risk based regulatory Leverage Ratio to constrain leverage in the banking sector. |
| Basel-II Guidelines require higher capital requirement for claims that are past due for ‘90 days and more’. | The Guidelines require higher capital requirement for claims that are past due for ‘60 days and more’, which was earlier required for past due for ‘90 days or more’ in the previous guideline. |
| There was no liquidity standard in Basel-II. | Basel III developed two minimum standards for liquidity which are Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). |
| Disclosures: | Disclosures on leverage ratio, liquidity ratio and remuneration are newly added in the Guideline. |