The initial phase of Basel III reforms (B3R) focused on improving the quality of bank regulatory capital by focusing on common equity tier 1 (CET1) capital so that banks can withstand losses in times of stress. Other forms of loss-absorbing capital, namely additional tier 1 (AT1), can also be used. Only one jurisdiction, Switzerland, used AT1 as loss-absorbing ahead of CET1.
The reforms emphasised that capital buffers should be built up in good times and drawn down in times of stress to limit procyclicality. B3R specified a minimum leverage ratio requirement to constrain excess leverage in the banking system and complement the risk-weighted capital requirements. It also introduced liquidity ratios such as the Liquidity Coverage Ratio and Net Stable Funding Ratio to minimise liquidity risk.
The initial phase of B3R revised areas of the risk-weighted capital framework by tweaking global standards for market risk, counterparty credit risk and securitisation.
This year, the final Basel III reforms started. The final reforms focused on the “denominator” of the CET1 ratio. Under Basel II, banks were allowed to use their advanced internal-ratings-based (IRB) approach for credit risk, which will enable banks to estimate the probability of default (PD), loss-given default (LGD), exposure at default (EAD) and maturity of exposure for asset classes. The Basel Committee found that the RWAs based on advanced IRB diverged significantly for the same assets in different banks.
Hence, the Basel Committee recommends that banks use a foundation IRB approach for exposures that cannot be modelled robustly and prudently. These include exposures to large and mid-sized corporates, as well as exposures to banks and other financial institutions.
The revised IRB framework introduces minimum “floor” values for bank-estimated IRB parameters used as inputs to calculate RWA to remove RWA variability among the banks.
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For example, a more granular approach has been developed for unrated exposures to banks and corporates and for rated exposures in jurisdictions where the use of credit ratings is permitted.
For exposures to banks, some of the risk weights for rated exposures have been recalibrated. Risk weights for unrated exposures are more granular than the existing flat risk weight.
A specific risk weight applies to exposures to small and medium-sized enterprises (SMEs). In addition, the revised standardised approach includes a standalone treatment for exposures to project finance, project finance and commodities finance.
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Risk-weights for residential real estate exposures vary based on the loan-to-value (LTV) ratio of the mortgage. More risk-sensitive risk weights are recommended for commercial real estate exposures compared to flat risk-weights previously.
Elsewhere, a modification in the capital charges for potential mark-to-market losses of derivative instruments due to the deterioration in a counterparty’s creditworthiness has also been recommended to make the charge more risk-sensitive, robust and consistent.
