Third Basel Accord: A Comprehensive Guide

The Third Basel Accord is a significant milestone in banking regulation, aimed at improving the risk management practices of banks worldwide. It was introduced in 2006.

The accord sets a new capital requirement framework for banks, known as Basel II, which is more comprehensive than its predecessors. Basel II takes into account the credit risk, market risk, and operational risk faced by banks.

One of the key features of Basel II is the introduction of a more sophisticated risk assessment system, known as the Internal Rating-Based (IRB) approach. This approach allows banks to use their own risk models to determine the credit risk of their assets.

Banks are required to hold a minimum amount of capital against their assets, which is calculated based on the risk of those assets.

The third Basel Accord, also known as Basel III, was a response to the 2007-09 financial crisis. It aimed to strengthen banking supervision and regulation.

Basel I, the first Basel Accord, was introduced in 1988 and established the Basel Capital Accord, which set minimum capital requirements for banks. This marked the beginning of international cooperation in banking supervision.

Basel II, introduced in 2004, built upon Basel I and introduced a new capital framework that took into account a bank's risk profile. However, it was criticized for being too lenient.

Here's a brief overview of the Basel Accords:

The Basel Accords have undergone several updates over the years, with the most recent one being Basel III.

The Basel Accords were developed over several years beginning in the 1980s, with the Basel Committee on Banking Supervision (BCBS) founded in 1974 as a forum for regular cooperation between its member countries on banking supervisory matters.

The BCBS turned its attention to monitoring and ensuring the capital adequacy of banks and the banking system, leading to the development of the Basel Accords.

The Basel Accords are named after the city of Basel, Switzerland, where the BCBS is headquartered in the offices of the Bank for International Settlements (BIS).

The Basel I accord was originally organized by central bankers from the G10 countries, who were working toward building new international financial structures to replace the recently collapsed Bretton Woods system.

Basel II, an extension of Basel I, was introduced in 2004, creating a more comprehensive risk management framework by creating standardized measures for credit, operational, and market risk.

Basel II also focused on market values, instead of book values, when looking at credit exposure, and strengthened supervisory mechanisms and market transparency by developing disclosure requirements to oversee regulations.

The Basel III reforms have now been integrated into the consolidated Basel Framework, which comprises all of the current and forthcoming standards of the Basel Committee on Banking Supervision.

Basel III requires banks to have a minimum amount of common equity and a minimum liquidity ratio, and includes additional requirements for what the Accord calls "systemically important banks", or those financial institutions that are considered "too big to fail."

Risk management is a crucial aspect of the Third Basel Accord. The accord has implemented a framework for limiting large exposure to external and internal counterparties, which was introduced in 2018.

Banks are now required to calculate their exposures based on the "economic value of equity" (EVE) under prescribed interest rate shock scenarios. This new approach became effective in 2018.

To mitigate the impact of internal losses, banks can focus on improving the quality of historical loss data and changing behaviors and culture. Formalizing definitions of operational risk events and improving incident identification and reporting can give operational risk managers the insights needed to reduce losses moving forward.

By aligning operational losses with business unit and executive performance, managers can be empowered to change their business environment and manage risks more proactively.

Here are some key areas of focus for banks to improve their risk management:

By implementing these strategies, banks can better manage their risks and improve their overall performance.

Tier 2 capital is a crucial component of a bank's risk management strategy. Tier 2 capital requirements are set to ensure that it, when combined with Tier 1 capital, totals at least 8% of a bank's risk-weighted assets.

This means that banks need to carefully manage their Tier 2 capital to meet these regulatory requirements. Tier 2 capital can be in the form of subordinated debt or preferred shares.

Banks must balance their Tier 2 capital with other risk management strategies to maintain a healthy risk profile.

The leverage ratio is a crucial aspect of risk management in banking. It's calculated by dividing Tier 1 capital by the bank's leverage exposure.

In simple terms, the leverage ratio measures how much of a bank's assets are backed by its own capital. A higher ratio indicates a lower risk, as the bank has more capital to absorb potential losses.

Basel III introduced a minimum leverage ratio of 3%, which is also the requirement in the EU. This means that banks must have at least 3% of their assets backed by their own capital.

In the US, the supplemental leverage ratio is defined as Tier 1 capital divided by total assets. It must be above 3.0%, and large banks and systemically important financial institutions must meet a minimum ratio of 5%.

Here's a quick rundown of the leverage ratio requirements in different regions:

The UK has a slightly higher minimum leverage ratio of 3.25% for banks with deposits greater than £50 billion. This is due to the PRA's differing treatment of central bank reserves in the leverage ratio calculation.

The leverage ratio has undergone significant changes over the years. In 2011, supervisory monitoring began, and by 2018, it became a mandatory part of Basel III requirements.

Liquidity is a critical aspect of risk management that banks need to prioritize. In 2014, the Federal Reserve Board of Governors approved a U.S. version of the liquidity coverage ratio, which has more stringent definitions of high-quality liquid assets (HQLA) and total net cash outflows.

This rule excludes certain privately issued mortgage-backed securities that are eligible under Basel III, and also doesn't include bonds and securities issued by financial institutions, which can become illiquid during a financial crisis. The rule is also modified for banks with less than $250 billion in total assets or $10 billion in on-balance-sheet foreign exposure.

The liquidity coverage ratio (LCR) requires banks to hold sufficient HQLA to cover their total net cash outflows over 30 days under a stressed scenario. 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.

Regulators can allow banks to dip below their required liquidity levels per the LCR during periods of stress. The LCR has a gradual implementation schedule, increasing from 60% in 2015 to 100% in 2019.

Here's a timeline of key milestones for liquidity requirements:

The Net Stable Funding Ratio (NSFR) requires banks to hold sufficient stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

Managing Counterparty Exposure is crucial for any business or institution. A new framework for exposures to Central Counterparties (CCPs) was introduced in 2017.

The Standardised Approach for Counterparty Credit Risk (SA-CCR) was implemented in 2017, replacing the Current Exposure method. This framework is used to measure the potential future exposure of derivative transactions in the leverage exposure measure and non-modelled Risk Weighted Asset calculations.

In 2018, a framework for limiting large exposure to external and internal counterparties was implemented. This framework helps prevent significant losses in case of default by a counterparty.

The Bank of England is in the process of implementing the Basel III framework on large exposures in the UK, set to take effect in 2024. This will further regulate and limit large exposure to external and internal counterparties.

Interest Rate Risk in the Banking Book is a crucial aspect of risk management, especially for banks. New rules for interest rate risk in the banking book became effective in 2018.

Banks are now required to calculate their exposures based on "economic value of equity" (EVE). This approach helps them accurately assess their risk levels.

Interest rate shock scenarios are used to determine potential losses. Banks must consider a set of prescribed scenarios to ensure they're prepared for any outcome.

By understanding and managing interest rate risk, banks can reduce their exposure to potential losses. This enables them to make more informed decisions and maintain stability in the financial system.

The Trading Book Review is a crucial aspect of Risk Management. It involves a thorough examination of the trading book to ensure that it is in line with regulatory requirements.

One key change that has occurred is the shift from Value at Risk (VaR) to a better calibrated standardized approach or internal model approval (IMA) for an expected shortfall measure. This change reflects a more sophisticated understanding of market risk.

The new approach is designed to provide a more accurate assessment of potential losses. By focusing on expected shortfall, banks can better manage their risk and make more informed decisions.

The Fundamental Review of the Trading Book has also led to the introduction of minimum capital requirements based on the new approach. This ensures that banks have sufficient capital to absorb potential losses.

Overall, the Trading Book Review is an essential tool for banks to manage their risk effectively.

Banks must focus on improving the quality of historical loss data to reduce operational losses. This involves formalizing definitions of operational risk events and improving incident identification and reporting.

To mitigate the impact of internal losses, banks can change behaviors and culture. By aligning operational losses with business unit and executive performance, managers can be empowered to change their business environment and manage risks more proactively.

Improving the quality of historical loss data is crucial. This can be achieved by formalizing definitions of operational risk events and improving incident identification and reporting. By doing so, operational risk managers can gain the insights needed to reduce losses moving forward.

Here are some strategies to improve the quality of historical loss data:

By focusing on these strategies, banks can take control of internal losses and reduce the impact of the internal loss factor in determining operational risk capital calculations.

The Basel Accords were set up by the Basel Committee on Bank Supervision (BCBS), created by central bank governors of the G10 countries in response to bank failures in Germany and the U.S. in the 1970s.

The BCBS was founded in 1974 as a forum for regular cooperation between its member countries on banking supervisory matters. Its original aim was to enhance financial stability by improving supervisory knowhow and the quality of banking supervision worldwide.

The BCBS has members from over 30 countries, including Australia, Argentina, Belgium, Canada, Brazil, China, France, Hong Kong, Italy, Germany, Indonesia, India, Korea, the United States, the United Kingdom, Luxembourg, Japan, Mexico, Russia, Saudi Arabia, Switzerland, Sweden, the Netherlands, Singapore, South Africa, Turkey, and Spain.

The BCBS is headquartered in the offices of the Bank for International Settlements (BIS) in Basel, Switzerland. This is where the BCBS gets its name, the Basel Accords.

The BCBS's main goal is to improve the consistency of banking regulations worldwide. To achieve this, it has implemented various standards, including the Basel III accord, which was endorsed by the G20 in 2012. The BCBS monitors the implementation of these standards through its Regulatory Consistency Assessment Programme (RCAP).

Under the RCAP, the BCBS publishes semiannual reports on members' progress in implementing Basel standards. It also conducts peer reviews to assess members' implementation of the standards. Between 2012 and 2016, the BCBS reviewed all member jurisdictions' implementation of the risk-based capital framework.

Here are some key dates related to the implementation of the Basel Accords:

The BCBS's efforts to improve banking regulations have led to significant progress in the implementation of the Basel Accords. However, there is still much work to be done to achieve the goal of consistent banking regulations worldwide.