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Basel III and Capital Requirements Directive (CRD IV)

Basel III is the new global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee12 on Banking Supervision in 2010 to 2011. Different from Basel II (which concentrated on credit, market and operational risk), the main focus of Basel III is on: (1) capital requirements; (2) liquidity requirements; (3) the leverage ratio of banks; and (4) a substantial strengthening and unification of the supervision of the financial sector. Basel III also reinforced the rules covering market risk, particularly the ones that deal with counterparty risk management and created a new category of financial institutions, the systemically important financial institutions (SIFIs, ‘the ones too big to fail’). However, the rules regarding operational risk remained unchanged from Basel II: [1]

• In addition the local regulator may add a discretionary countercyclical buffer of up to 2.5 per cent of capital during periods of high credit growth.

All this will raise the total capital to be held against risk-weighted assets to 10.5 per cent against 8.0 per cent at the time of writing.

  • 2. Basel III will introduce minimum liquidity standards:
    • • A short-term (30 days) liquidity coverage ratio (LCR) is a ratio designed to ensure that financial institutions have the necessary liquid assets on hand to ride out short-term liquidity disruptions. Banks are required to hold an amount of highly liquid assets, such as cash or Treasury bonds, equal to or greater than their net cash outflow over a 30-day period.
    • • A longer-term structural liquidity ratio called net stable funding ratio (NSFR) that measures how much stable funding a bank has to tolerate a year-long liquidity crisis. This funding ratio seeks to ensure that long-term assets are funded by long-term, stable liabilities.
  • 3. Introduction of a leverage ratio to limit the amount of maximum leverage: the sum of on-balance sheet and off-balance sheet assets may not be greater than 33 times the bank’s capital.
  • 4. Further tightening of counterparty risk management requirements:
    • • Introduction of credit valuation adjustment (CVA) indicators, measuring the risk due to the deterioration in a counterparty’s credit rating.
    • • Strengthening of the capital requirements for counterparty credit exposures to large regulated financial entities and to unregulated financial entities arising from banks’ derivatives, repo and securities financing transactions.

All of the above-mentioned measures will add to the cost base of banks and will either force some of them to shift these costs or reduce those types of businesses which will be especially affected by the new rules (mainly market-related transactions). So far the impact on the economic growth perspectives in the CEE region has not been adequately assessed. Still, the Basel III regulatory requirements could prove to be a challenge for banks active in CEE. While the quantitatively and qualitatively tighter capital requirements under Basel III should not pose significant challenges for the CEE subsidiaries of foreign banks (CEE banking sectors are generally overcapitalized), they obviously require the further build-up of high-quality capital at the group level during the gradual phasing-in of Basel III.

The new requirements regarding liquidity coverage and net stable funding ratios, however, could represent a major challenge for CEE banks. In view of the fact that the new rules will force banks to reconsider their present funding policies and to substantially adjust their portfolios of funding products, the Basel Committee has since decided to postpone the implementation of these liquidity requirements until the end of 2018. This should give all banks concerned more time to adjust their business strategies to the tighter regulatory environment.

  • [1] Basel III will require banks to increase their capital: • Tier 1 capital will have to be increased from 4 per cent (Basel II) to6 per cent of risk weighted assets while the list of eligible tier 2capital instruments will be reduced. • Basel III will introduce a mandatory capital buffer of 2.5 percent - in effect requiring banks to add this percentage to their totalcapital.
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