Basel Committee on Banking Supervision

B A N K F O R I N T E R N AT I O N A L S E T T L E M E N T S

Finalising Basel III

In brief

2010

2017
reforms
December 2017
 Basel III
What is Basel III? What do the 2017 reforms do?

The Basel III framework The Committee’s Basel III reforms complement the initial
is a central element of phase of the Basel III reforms announced in 2010. The 2017
the Basel Committee’s reforms seek to restore credibility in the calculation of risk-
response to the global weighted assets (RWAs) and improve the comparability
financial crisis. It of banks’ capital ratios. RWAs are an estimate of risk that
addresses a number determines the minimum level of regulatory capital a bank
of shortcomings in the must maintain to deal with unexpected losses. A prudent
pre-crisis regulatory and credible calculation of RWAs is an integral element of
framework and provides a the risk-based capital framework.
foundation for a resilient
banking system that will
help avoid the build-up Why are the 2017 reforms necessary?
of systemic vulnerabilities.
The framework will allow The 2017 reforms address weaknesses that were revealed
the banking system to by the global financial crisis.
support the real economy
through the economic • Credibility of the framework: A range of studies found
cycle. an unacceptably wide variation in RWAs across banks
that cannot be explained solely by differences in the
riskiness of banks’ portfolios. The unwarranted variation
makes it difficult to compare capital ratios across
banks and undermines confidence in capital ratios. The
reforms will address this to help restore the credibility
of the risk-based capital framework.

• Internal models: Internal models should allow for

more accurate risk measurement than the standardised
approaches developed by supervisors. However,
incentives exist to minimise risk weights when internal
models are used to set minimum capital requirements.
In addition, certain types of asset, such as low-default
exposures, cannot be modelled reliably or robustly.
The reforms introduce constraints on the estimates
banks make when they use their internal models for
regulatory capital purposes, and, in some cases, remove
the use of internal models.

1
 Basel III: main features
$

Increase the level and Enhance risk Constrain bank leverage Improve bank liquidity Limit procyclicality
quality of capital capture

Banks required to maintain Capital requirements for A leverage ratio constrains The Liquidity Coverage Banks retain earnings to
more capital of higher quality market risk rise significantly. the build-up of debt to Ratio requires banks to hold build up capital buffers
2010

to cover unexpected losses. Requirements are fund banks' investment and sufficient liquid assets to during periods of high
Minimum Tier 1 capital rises calculated based on 12 activities (bank leverage), sustain them for 30 days economic growth so that
from 4% to 6%, of which at months of market stress. reducing the risk of a during times of stress. The they can draw them down
least three quarters must be Credit Valuation deleveraging spiral during Net Stable Funding Ratio during periods of
the highest quality (common Adjustment risk is now downturns. encourages banks to better economic stress.
shares and retained earnings). included in the framework. match the duration of their
Global systemically important assets and liabilities.
banks (G-SIBs) are subject to
additional capital
requirements.

Revisions to the Global systemically

standardised approaches important banks (G-SIBs)
for calculating credit risk, are subject to higher
market risk, Credit leverage ratio
Valuation Adjustment and requirements.
2017

operational risk mean

greater risk sensitivity and
comparability. Constraints
on using internal models
aim to reduce unwarranted
variability in banks'
calculations of RWAs.

An output floor limits the

benefits banks can derive
from using internal models
to calculate minimum
capital requirements.
2
 Focus on
risk-weighted assets
What is regulatory capital?

While the first phase of Banks fund their investments with capital and debt, such as
Basel III focused largely customer deposits. Capital can absorb losses in a way that
on the capital side of the reduces the likelihood of a bank failing and the impact if it
capital ratio calculation does. Regulatory capital consists of:
(the numerator), the 2017
reforms concentrate on • Common Equity Tier 1 – common shares, retained earnings
the calculation of RWAs and other reserves.
(the denominator). • Additional Tier 1 – capital instruments with no fixed
maturity.
• Tier 2 – subordinated debt and general loan-loss reserves.

Banks with more regulatory capital are better able to fund

lending growth.

The capital ratio is the

amount of regulatory
capital divided by the Regulatory
amount of risk-weighted Risk-based capital
assets. The greater the capital ratio =
amount of risk-weighted Risk-weighted
assets, the more capital assets
is needed, and vice versa. Other

Market Operational
Credit risk
risk risk

What are risk-weighted assets?

• A bank’s assets typically include cash, securities and loans made to individuals, businesses,
other banks, and governments. Each type of asset has different risk characteristics. A risk
weight is assigned to each type of asset, as an indication of how risky it is for the bank to
hold the asset.
• To work out how much capital banks should maintain to guard against unexpected losses,
the value of the asset (ie the exposure) is multiplied by the relevant risk weight. Banks need
less capital to cover exposures to safer assets and more capital to cover riskier exposures.

3
 Improve the treatment
of credit risk
Credit risk, the risk of Most banks around the world use the standardised approach
loss due to a borrower (SA) for credit risk. Under this approach, supervisors set the
being unable to repay risk weights that banks apply to their exposures to determine
a debt in full or in part, RWAs. This means that banks do not use their internal models
accounts for the bulk of to calculate risk-weighted assets.
most banks’ risk-taking
activities and regulatory The main changes to the SA for credit risk will:
capital requirements.
There are two broad • Enhance risk sensitivity while keeping the SA for credit risk
approaches to calculating sufficiently simple.
RWAs for credit risk: the - Provide for a more detailed risk weighting approach
standardised approach instead of a flat risk weight, particularly for residential
and the internal ratings- and commercial real estate.
based approach. • Reduce reliance on external credit ratings.
- Require banks to conduct sufficient due diligence when
using external ratings.
- Have a sufficiently detailed non-ratings-based
approach for jurisdictions that cannot or do not wish
to rely on external credit ratings.

The internal ratings-based (IRB) approach for credit risk allows banks, under certain conditions, to
use their internal models to estimate credit risk, and therefore RWAs. The 2017 reforms introduced
some constraints to banks’ estimates of risk parameters. There are two main IRB approaches:
Foundation IRB (F-IRB) and Advanced IRB (A-IRB).

The main changes to the Exposure class Methods Change in available

IRB approach for credit available under methods relative to
risk will: the new credit current credit risk
risk standards standard
• Remove the option Banks and other financial SA or F-IRB A-IRB removed
to use the A-IRB institutions
approach for Corporates belonging SA or F-IRB A-IRB removed
exposures to financial to groups with total
institutions and large consolidated revenues
corporates. No IRB exceeding EUR 500m
approach can be used Other corporates SA, F-IRB or A-IRB No change
for equity exposures.
• Where the IRB Specialised lending SA, supervisory No change
slotting, F-IRB or
approach is retained,
A-IRB
minimum levels
are applied on the Retail SA or A-IRB No change
probability of default Equity SA All IRB approaches
and for other inputs. removed

4
 Streamline the treatment
of operational risk
The financial crisis The 2017 reforms:
highlighted weaknesses
in calculating capital • Simplify the framework by replacing the four current
requirements for approaches with a single standardised approach.
operational risk, or the risk • Make the framework more risk-sensitive by combining a
of loss due to inadequate refined measure of gross income with a bank’s own internal
or failed internal processes, loss history over 10 years.
people and systems or • Make it easier to compare RWAs from bank to bank by
from external events. The removing the option to use multiple approaches and the
capital requirements were option to use internal models.
not enough to cover the
losses incurred by some
banks. And the sources Operational
Business Internal
of such losses – including
those related to fines
risk capital
= indicator
component x loss
multiplier

for misconduct or poor

systems and controls – are
also hard to predict using
internal models.
To cover against the
risk of loss due to A progressive A risk-sensitive
inadequate or failed measure of income component that
internal processes, that increases with captures a bank's own
people and systems bank size internal losses
or from external
events

Significant operational risk losses during crisis

Conduct-related fines
70 120

60 100
50
80
40
60
30
40
20

10 20

0 0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Fines (€ bn) (LHS) Number of fines (RHS)

Sources: Le Monde; Basel Committee Secretariat calculations.
Conduct-related fines for a sample of 111 banks. Fines converted to euros based on relevant exchange rate as at 20 May 2016.

5
 Add a leverage ratio
surcharge for the
The leverage ratio
introduced by Basel III
largest banks
acts as a non-risk-based
backstop to the risk-based The 2017 reforms introduce a leverage ratio buffer for G-SIBs.
capital rules. This limits Basel III had already prescribed a risk-based capital buffer for
any excessive build-up G-SIBs. Therefore, the leverage ratio buffer is necessary to make
in leverage. Under this sure that the leverage ratio continues to act as an appropriate
requirement, the Tier backstop to the risk-based requirements for G-SIBs.
1 capital of the bank
must be at least 3% of
the bank’s on- and off-
balance sheet exposures.
The leverage ratio applies Tier 1 capital
Leverage ≥ 3%
=
to all internationally active ratio On- and off-balance sheet exposures
banks.
(including derivatives, repos and other
securities financing transactions)

The leverage ratio buffer

for each G-SIB will be set at
50% of its risk-based capital
buffer. For example, a bank
with a 2% risk-based buffer
will have a 1% leverage
ratio buffer and so will be
expected to maintain a
leverage ratio of at least 4%.

6
 Create a more robust,
risk-sensitive output
The 2017 reforms replace
the existing capital floor
floor
with a more robust, risk-
sensitive output floor
based on the revised
standardised approaches. • The revised output floor limits the amount of capital
Jurisdictions have not benefit a bank can obtain from its use of internal models,
implemented the existing relative to using the standardised approaches.
floor consistently, partly
because of differing • Banks’ calculations of RWAs generated by internal models
interpretations of the cannot, in aggregate, fall below 72.5% of the risk-weighted
requirement and also assets computed by the standardised approaches. This
because it is based limits the benefit a bank can gain from using internal
on Basel I standards, models to 27.5%.
which many banks and
jurisdictions no longer
apply.
The output floor at work
100

80 Example of
72.5% additional
RWAs
60 needed
under
40 output floor

20

0
With standardised With internal
approach models

RWAs Output floor

7
 Banks have plenty of
time to prepare

The implementation date

and available phase-in 2017 reforms Implementation date
arrangements for the
output floor will help Revised standardised
1 January 2022
ensure a reasonable and approach for credit risk
orderly transition to the Revised internal ratings-based
1 January 2022
new standards. framework for credit risk
Revised Credit Valuation
1 January 2022
Adjustment framework
Revised operational risk
1 January 2022
framework
Revised market risk
1 January 2022
framework
Existing exposure definition:
1 January 2018
Revised exposure definition:
Leverage ratio
1 January 2022
G-SIB buffer:
1 January 2022

1 January 2022: 50%

1 January 2023: 55%

1 January 2024: 60%

Output floor*
1 January 2025: 65%

1 January 2026: 70%

1 January 2027: 72.5%

(steady state calibration)

* In addition, at national discretion, supervisors may cap the

increase in a bank’s total RWAs that results from the application
of the output floor during its phase-in period. The transitional
cap on the increase in RWAs will be set at 25% of a bank’s
RWAs before the application of the floor. The cap will be
removed on 1 January 2027.