Basel III: What It Is, Capital Requirements, and Implementation

What Is Basel III?

Basel III is an international regulatory accord that introduced a set of reforms designed to mitigate risk within the international banking sector by requiring banks to maintain certain leverage ratios and keep certain levels of reserve capital on hand. Begun in 2009, it is still being implemented as of 2022.

Understanding Basel III

Basel III was rolled out by the Basel Committee on Banking Supervision—a consortium of central banks from 28 countries, based in Basel, Switzerland—shortly after the financial crisis of 2007–2008. During that crisis, many banks proved to be overleveraged and undercapitalized, despite earlier reforms.

Although the voluntary deadline for implementing the new rules was originally 2015, the date has been repeatedly pushed back and currently stands at Jan. 1, 2023.

Also referred to as the Third Basel Accord, Basel III is part of a continuing effort to enhance the international banking regulatory framework begun in 1975. It builds on the Basel I and Basel II accords in an effort to improve the banking system’s ability to deal with financial stress, improve risk management, and promote transparency. On a more granular level, Basel III seeks to strengthen the resilience of individual banks to reduce the risk of system-wide shocks and prevent future economic meltdowns.

Minimum Capital Requirements Under Basel III

Banks have two main silos of capital that are qualitatively different from one another. Tier 1 refers to a bank’s core capital, equity, and the disclosed reserves that appear on the bank’s financial statements. If a bank experiences significant losses, Tier 1 capital provides a cushion that can allow it to weather stress and maintain a continuity of operations.

By contrast, Tier 2 refers to a bank’s supplementary capital, such as undisclosed reserves and unsecured subordinated debt instruments.

Tier 1 capital is more liquid and considered more secure than Tier 2 capital.

A bank’s total capital is calculated by adding both tiers together. Under Basel III, the minimum total capital ratio that a bank must maintain is 8% of its risk-weighted assets (RWAs), with a minimum Tier 1 capital ratio of 6%. The rest can be Tier 2.

While Basel II also imposed a minimum total capital ratio of 8% on banks, Basel III increased the portion of that capital that must be in the form of Tier 1 assets, from 4% to 6%. Basel III also eliminated an even riskier tier of capital, Tier 3, from the calculation.

Capital Buffers for Tough Times

Basel III introduced new rules requiring that banks maintain additional reserves known as countercyclical capital buffers—essentially a rainy day fund for banks. These buffers, which may range from 0% to 2.5% of a bank’s RWAs, can be imposed on banks during periods of economic expansion. That way, they should have more capital at the ready during times of economic contraction, such as a recession, when they face greater potential losses.

So, considering both the minimum capital and buffer requirements, a bank could be required to maintain reserves of up to 10.5%.

Countercyclical capital buffers must also consist entirely of Tier 1 assets.

Leverage and Liquidity Measures

Basel III likewise introduced new leverage and liquidity requirements aimed at safeguarding against excessive and risky lending, while ensuring that banks have sufficient liquidity during periods of financial stress. In particular, it set a leverage ratio for so-called “global systemically important banks.” The ratio is computed as Tier 1 capital divided by the bank’s total assets, with a minimum ratio requirement of 3%.

In addition, Basel III established several rules related to liquidity. One, the liquidity coverage ratio, requires that banks hold a “sufficient reserve of high-quality liquid assets (HQLA) to allow them to survive a period of significant liquidity stress lasting 30 calendar days.” HQLA refers to assets that can be converted into cash quickly, with no significant loss of value.

Another liquidity-related provision is the net stable funding (NSF) ratio, which compares the bank’s “available stable funding” (essentially capital and liabilities with a time horizon of more than one year) with the amount of stable funding that it is required to hold based on the liquidity, outstanding maturities, and risk level of its assets. A bank’s NSF ratio must be at least 100%. The goal of this rule is to create “incentives for banks to fund their activities with more stable sources of funding on an ongoing basis” rather than load up their balance sheets with “relatively cheap and abundant short-term wholesale funding.”

The Bottom Line

Basel III is a set of international banking reforms and the third of the Basel Accords. It was created by the Switzerland-based Basel Committee on Banking Supervision, made up of central banks from around the world, including the Federal Reserve in the United States. Basel III aims to address some of the regulatory shortcomings of Basel I and Basel II that became clear during the financial crisis of 2007–2008. Basel III is scheduled for full implementation by 2028.