What is Basel III?

The raft of documents produced by the regulators across the world has certainly added to the noise and confusion that the credit crisis has left in its wake. The Basel Committee on Banking Supervision (BCBS) has developed its recommendations to G20 institutions, realizing that radical changes in the regulatory regime could endanger the still fragile recovery after the crisis. So torn between a radical overhaul, and a fear of rocking the already rocky boat, they have produced three major documents:

BCBS 159: The first (BCBS 159) has been ratified by the G20 countries and will be implemented by the end of 2010 in most countries. BCBS 159 focuses on amending the internal models methods (IMM) associated with market risk in the trading book. It requires the introduction of Stress VaR capital calculations in addition to the existing general market var capital calculation. It also requires for international banks implementing internal models for specific risk the additional assignment of Incremental Risk Capital (IRC) – capturing default risk, credit migration risk, credit spread risk in the trading book using similar techniques to those found in the banking book (IRB) – for example, it uses a more conservative confidence interval (99.9%) and a longer time horizon (1 year)

BCBS 164: This has been proposed but not yet ratified. It imposes changes on capital (more focus on Tier 1 capital in general and equity in particular), yet more changes to counterparty credit risk capital in the trading book (above those required in BCBS 159), the imposition of countercyclical buffers and a general leverage ratio constraint. More interestingly it requires the development of macroprudential risk management that go beyond micro prudential risk management (focusing on the risks of particular institutions) and instead looks at the systemic risks of the entire network of institutions as part of a global economy.

BCBS 165: Like BCBS 164, this has yet to be ratified but focuses on the need to implement specific metrics for liquidity risk, a short term 30 day minimum liquidity coverage ratio to handle a major stress scenario, a long term 1 year net stable funding ratio to define a minimum stable funding requirement and finally a set of standard liquidity metrics that all regulators will take into account when evaluating the health of a banking institution.