The core of Basel III is the requirement for banks to hold much more capital and liquidity in proportion to their outstanding investments than they have had to so far. As from 2013, the rules will be introduced gradually and they will ultimately have to be fully effective in 2019. The expected impact is such that a thorough orientation is required now.
The summer of 2007 saw a tidal wave of large-scale defaults in respect of American mortgage loans. The banks were hit hard as this snowballed across the world. A major financial crisis unfolded, growing into an economic crisis and urging regulatory agencies to re-examine the capital requirements of Basel I and Basel II.
Since July 2008 the Basel Committee for Banking Supervision has been busy defining a new capital agreement for banks across the world (the so-called Basel III ). The result so far has been three Capital Requirements Directives issued by the European Committee, containing concrete actions and requirements regarding the banks’ risk, capital and liquidity management .
The new requirements included in Basel III aim to enhance the quality of the banks’ capital reserves and increase the amounts involved. The capital requirements for certain products will increase, while banks are encouraged to create additional capital buffers during prosperous economic times so they will be better positioned to absorb losses during periods of economic distress. Any banks failing to comply with the additional buffer or failing to do so sufficiently will be constrained in their possibility to pay dividends or performance related bonuses.
Besides stricter capital requirements, Basel III has a major impact on liquidity management too. The new liquidity standards are based on a stress test. What’s more, Basel III introduces new long-term liquidity standards to diminish the mismatch between terms of assets and liabilities. The following is a brief explanation of the stricter rules compared with Basel II.
Over the next few years - formally as from 2013, but probably sooner - banks will have to form major reserves. Under the current rules they need to hold a mere 2% of capital in proportion to their outstanding investments. Basel III now increases this to 7% (4.5% hard buffer and an additional 2.5% margin for bad times). Banks will thus not distribute their profits of the coming years: they will add them to their capital buffers. If they are to meet the new requirements many banks will have to issue shares to raise additional funds as well.