The Basel III rules are a regulatory framework designed to strengthen financial institutions by placing guidelines pertaining to leverage ratios, capital requirements and liquidity. For investors in the banking sector, they create confidence that some of the mistakes made by banks that caused and contributed to the financial crisis in 2007-2008 will not be repeated.
Basel III is designed to be a voluntary effort and was finalized with input and feedback from banks and financial regulators. Many countries have integrated aspects of Basel III into their own domestic regulatory statutes for banks. One of the lessons of the financial crisis was that banks with high leverage ratios need to be appropriately regulated instead of self-regulating. These were the banks that were the most distressed during 2007-2008.
As these banks teetered on the edge of survival, their potential plunge had the potential to take down healthy institutions with it. If these banks unraveled, their assets would be sold at fire-sale prices. This would drive down the value of all types of assets, leading to asset values being marked down on healthy bank balance sheets and creating distress for them. The unique, interconnected nature of the banking system needs confidence in the system at the very core to survive.
In normal economic circumstances, high leverage can enhance returns, but it can be disastrous when prices fall and liquidity recedes as it tends to do in crises. During the financial crisis, many banks with high leverage became insolvent, necessitating government intervention and bailouts. Under Basel III, a minimum leverage ratio has been instituted. This means high-quality assets, dubbed Tier 1, have to be above 3% of all total assets.
Capital requirements are also a part of Basel III. Banks are required to hold 4.5% of risk-weighted assets in the form of their own equity. This rule is an effort to make banks have skin in the game when it comes to making decisions to reduce the agency problem. More capital rules include 6% of risk-weighted assets being of Tier 1 quality. Risk-weighted assets are the most vulnerable during a downturn, so these rules will protect the banks.
Another element of Basel III is required liquidity ratios. The liquidity coverage ratio mandates that banks must hold high-quality, liquid assets that would cover the bank's cash outflows for a minimum of 30 days in the event of an emergency. The net stable funding requirement is for banks to have enough funding to last for a whole year in an emergency.
For bank investors, this increases confidence in the strength and stability of banks' balance sheets. By reducing leverage and imposing capital requirements, it reduces banks' earning power in good economic times. Nevertheless, it makes banks safer and better able to survive and thrive under financial stress.
Financial institutions tend to be procyclical, meaning they grow fast during periods of economic expansion. However, during downturns, many go bust. Basel III would force them to add to long-term reserves and capital during good times, cushioning the inevitable distress when conditions turn sour.