standard on bank capital adequacy, stress testing and market liquidity risk. It was

agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and was

scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended

implementation until 31 March 2018. The third installment of the Basel Accords was developed

in response to the deficiencies in financial regulation revealed by the late-2000s financial

crisis. Basel III was supposed to strengthen bank capital requirements by increasing bank

liquidity and decreasing bank leverage. General Overview

Unlike Basel I and Basel II which are primarily related to the required level of bank loss

reserves that must be held by banks for various classes of loans and other investments and

assets that they have, Basel III is primarily related to the risks for the banks of a run

on the bank by requiring differing levels of reserves for different forms of bank deposits

and other borrowings. Therefore contrary to what might be expected by the name, Basel

III rules do not for the most part supersede the guidelines known as Basel I and Basel

II but work alongside them. Key principles

Capital requirements The original Basel III rule from 2010 was

supposed to require banks to hold 4.5% of common equity (up from 2% in Basel II) and

6% of Tier I capital (up from 4% in Basel II) of "risk-weighted assets" (RWA). Basel

III introduced "ad æitional capital buffers", (i) a "mandatory capital conservation buffer"

of 2.5% and (ii) a "discretionary counter-cyclical buffer", which would allow national regulators

to require up to another 2.5% of capital during periods of high credit growth.

Leverage ratio Basel III introduced a minimum "leverage ratio".

The leverage ratio was 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. In July 2013, the US Federal Reserve Bank announced that the minimum Basel

III leverage ratio would be 6% for 8 Systemically important financial institution (SIFI) banks

and 5% for their insured bank holding companies. Liquidity requirements

Basel III introduced two required liquidity ratios. The "Liquidity Coverage Ratio" was

supposed to require a bank to hold sufficient high-quality liquid assets to cover its total

net cash outflows over 30 days; the Net Stable Funding Ratio was to require the available

amount of stable funding to exceed the required amount of stable funding over a one-year period

of extended stress. US Version of the Basel Liquidity Coverage

Ratio Requirements On 24 October 2013, the Federal Reserve Board

of Governors approved an interagency proposal for the U.S. version of the Basel Committee

on Banking Supervision's (BCBS) Liquidity Coverage Ratio (LCR). The ratio would apply

to certain U.S. banking organizations and other systematically important financial institutions.

The comment period for the proposal is scheduled to close by 31 January 2014.

The U.S. LCR proposal came out significantly tougher than BCBS’s version, especially

for larger bank holding companies. The proposal requires financial institutions and FSOC designated

nonbank financial companies to have an adequate stock of High Quality Liquid Assets (HQLA)

that can be quickly liquidated to meet liquidity needs over a short period of time.

The LCR consists of two parts: the numerator is the value of HQLA, and the denominator

consists of the total net cash outflows over a specified stress period (total expected

cash outflows minus total expected cash inflows). The Liquidity Coverage Ratio applies to US

banking operations with assets of more than 10 billion. The proposal would require:

Large Bank Holding Companies (BHC) – those with over $250 billion in consolidated assets,

or more in on-balance sheet foreign exposure, and to systemically important, non-bank financial

institutions; to hold enough HQLA to cover 30 days of net cash outflow. That amount would

be determined based on the peak cumulative amount within the 30 day period.

Regional firms (those with between $50 and $250 billion in assets) would be subject to

a “modified” LCR at the (BHC) level only. The modified LCR requires the regional firms

to hold enough HQLA to cover 21 days of net cash outflow. The net cash outflow parameters

are 70% of those applicable to the larger institutions and do not include the requirement

to calculate the peak cumulative outflows Smaller BHCs, those under $50 billion, would

remain subject to the prevailing qualitative supervisory framework.

The US proposal divides qualifying High Quality Liquid Assets into three specific categories

(Level 1, Level 2A, and Level 2B). Across the categories the combination of Level 2A

and 2B assets cannot exceed 40% HQLA with 2B assets limited to a maximum of 15% of HQLA.

Level 1 represents assets that are highly liquid (generally those risk-weighted at 0%

under the Basel III standardized approach for capital) and receive no haircut. Notably,

the Fed chose not to include GSE-issued securities in Level 1, despite industry lobbying, on

the basis that they are not guaranteed by the full faith and credit of the US government.

Level 2A assets generally include assets that would be subject to a 20% risk-weighting under

Basel III and includes assets such as GSE-issued and -guaranteed securities. These assets would

be subject to a 15% haircut which is similar to the treatment of such securities under

the BCBS version. Level 2B assets include corporate debt and

equity securities and are subject to a 50% haircut. The BCBS and US version treats equities

in a similar manner, but corporate debt under the BCBS version is split between 2A and 2B

based on public credit ratings, unlike the US proposal. This treatment of corporate debt

securities is the direct impact of DFA’s Section 939 (i.e., the removal of references

to credit ratings) and further evidences the conservative bias of US regulators’ approach

to the LCR. The proposal requires that the LCR be at least

equal to or greater than 1.0 and includes a multiyear transition period that would require:

80% compliance starting 1 January 2015, 90% compliance starting 1 January 2016, and 100%

compliance starting 1 January 2017. Lastly, the proposal requires both sets of

firms (large bank holding companies and regional firms) subject to the LCR requirements to

submit remediation plans to U.S. regulators to address what actions would be taken if

the LCR falls below 100% for three consecutive days or longer.

Implementation Summary of originally (2010) proposed changes

in Basel Committee language First, the quality, consistency, and transparency

of the capital base will be raised.

Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained

earnings Tier 2 capital: supplementary capital, however,

the instruments will be harmonised Tier 3 capital will be eliminated.

Tier 1 capital: the predominant form of Tier 1 capital must be common shares and retained

earnings Tier 2 capital: supplementary capital, however,

the instruments will be harmonised Tier 3 capital will be eliminated.

Second, the risk coverage of the capital framework will be strengthened.

Promote more integrated management of market and counterparty credit risk

Add the CVA (credit valuation adjustment)-risk due to deterioration in counterparty's credit

rating Strengthen the capital requirements for counterparty

credit exposures arising from banks' derivatives, repo and securities financing transactions

Raise the capital buffers backing these exposures Reduce procyclicality and

Provide additional incentives to move OTC derivative contracts to qualifying central

counterparties (probably clearing houses). Currently, the BCBS has stated derivatives

cleared with a QCCP will be risk-weighted at 2% (The rule is still yet to be finalized

in the U.S.) Provide incentives to strengthen the risk

management of counterparty credit exposures Raise counterparty credit risk management

standards by including wrong-way risk Promote more integrated management of market

and counterparty credit risk Add the CVA (credit valuation adjustment)-risk

due to deterioration in counterparty's credit rating

Strengthen the capital requirements for counterparty credit exposures arising from banks' derivatives,

repo and securities financing transactions Raise the capital buffers backing these exposures

Reduce procyclicality and Provide additional incentives to move OTC

derivative contracts to qualifying central counterparties (probably clearing houses).

Currently, the BCBS has stated derivatives cleared with a QCCP will be risk-weighted

at 2% (The rule is still yet to be finalized in the U.S.)

Provide incentives to strengthen the risk management of counterparty credit exposures

Raise counterparty credit risk management standards by including wrong-way risk

Third, a leverage ratio will be introduced as a supplementary measure to the Basel II

risk-based framework,

intended to achieve the following objectives:

Put a floor under the build-up of leverage in the banking sector

Introduce additional safeguards against model risk and measurement error by supplementing

the risk based measure with a simpler measure that is based on gross exposures.

intended to achieve the following objectives:

Put a floor under the build-up of leverage in the banking sector

Introduce additional safeguards against model risk and measurement error by supplementing

the risk based measure with a simpler measure that is based on gross exposures.

Put a floor under the build-up of leverage in the banking sector

Introduce additional safeguards against model risk and measurement error by supplementing

the risk based measure with a simpler measure that is based on gross exposures.

Fourth, a series of measures is introduced to promote the build up of capital buffers

in good times that can be drawn upon in periods of stress ("Reducing procyclicality and promoting

countercyclical buffers").

Measures to address procyclicality:

Dampen excess cyclicality of the minimum capital requirement;

Promote more forward looking provisions; Conserve capital to build buffers at individual

banks and the banking sector that can be used in stress; and

Achieve the broader macroprudential goal of protecting the banking sector from periods

of excess credit growth.

Requirement to use long term data horizons to estimate probabilities of default,

downturn loss-given-default estimates, recommended in Basel II, to become mandatory

Improved calibration of the risk functions, which convert loss estimates into regulatory

capital requirements. Banks must conduct stress tests that include

widening credit spreads in recessionary scenarios.

Promoting stronger provisioning practices (forward looking provisioning):

Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,

EL amount := LGD*PD*EAD). Measures to address procyclicality:

Dampen excess cyclicality of the minimum capital requirement;

Promote more forward looking provisions; Conserve capital to build buffers at individual

banks and the banking sector that can be used in stress; and

Dampen excess cyclicality of the minimum capital requirement;

Promote more forward looking provisions; Conserve capital to build buffers at individual

banks and the banking sector that can be used in stress; and

Achieve the broader macroprudential goal of protecting the banking sector from periods

of excess credit growth.

Requirement to use long term data horizons to estimate probabilities of default,

downturn loss-given-default estimates, recommended in Basel II, to become mandatory

Improved calibration of the risk functions, which convert loss estimates into regulatory

capital requirements. Banks must conduct stress tests that include

widening credit spreads in recessionary scenarios. Requirement to use long term data horizons

to estimate probabilities of default, downturn loss-given-default estimates, recommended

in Basel II, to become mandatory Improved calibration of the risk functions,

which convert loss estimates into regulatory capital requirements.

Banks must conduct stress tests that include widening credit spreads in recessionary scenarios.

Promoting stronger provisioning practices (forward looking provisioning):

Advocating a change in the accounting standards towards an expected loss (EL) approach (usually,

EL amount := LGD*PD*EAD). Advocating a change in the accounting standards

towards an expected loss (EL) approach (usually, EL amount := LGD*PD*EAD).

Fifth,a global minimum liquidity standard for internationally active banks is introduced

that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term

structural liquidity ratio called the Net Stable Funding Ratio. (In January 2012, the

oversight panel of the Basel Committee on Banking Supervision issued a statement saying

that regulators will allow banks to dip below their required liquidity levels, the liquidity

coverage ratio, during periods of stress.) The Committee also is reviewing the need for

additional capital, liquidity or other supervisory measures to reduce the externalities created

by systemically important institutions. As of September 2010, proposed Basel III norms

asked for ratios as: 7–9.5% (4.5% + 2.5% (conservation buffer) + 0–2.5% (seasonal

buffer)) for common equity and 8.5–11% for Tier 1 capital and 10.5–13% for total capital.

On 15 April, the Basel Committee on Banking Supervision (“BCBS”) released the final

version of its “Supervisory Framework for Measuring and Controlling Large Exposures”

(“SFLE”) that builds upon longstanding BCBS guidance on credit exposure concentrations.

U.S. implementation The U.S. Federal Reserve announced in December

2011 that it would implement substantially all of the Basel III rules. It summarized

them as follows, and made clear they would apply not only to banks but also to all institutions

with more than US$50 billion in assets: "Risk-based capital and leverage requirements"

including first annual capital plans, conduct stress tests, and capital adequacy "including

a tier one common risk-based capital ratio greater than 5 percent, under both expected

and stressed conditions" – see scenario analysis on this. A risk-based capital surcharge

Market liquidity, first based on the US's own "interagency liquidity risk-management

guidance issued in March 2010" that require liquidity stress tests and set internal quantitative

limits, later moving to a full Basel III regime - see below.

The Federal Reserve Board itself would conduct tests annually "using three economic and financial

market scenarios." Institutions would be encouraged to use at least five scenarios reflecting

improbable events, and especially those considered impossible by management, but no standards

apply yet to extreme scenarios. Only a summary of the three official Fed scenarios "including

company-specific information, would be made public" but one or more internal company-run

stress tests must be run each year with summaries published.

Single-counterparty credit limits to cut "credit exposure of a covered financial firm to a

single counterparty as a percentage of the firm's regulatory capital. Credit exposure

between the largest financial companies would be subject to a tighter limit."

"Early remediation requirements" to ensure that "financial weaknesses are addressed at

an early stage". One or more "triggers for remediation—such as capital levels, stress

test results, and risk-management weaknesses—in some cases calibrated to be forward-looking"

would be proposed by the Board in 2012. "Required actions would vary based on the severity of