Shearman & Sterling LLP | Financial Regulatory Developments Focus | Basel III Finally Finalized
Financial Regulatory Developments Focus
  • Basel III Finally Finalized
    The Basel Committee on Banking Supervision has published the last part of the Basel III reforms. The revisions are to the standardized approach and the Internal Ratings-Based approach for credit risk, the Credit Valuation Adjustment risk framework, the leverage ratio framework, including the introduction of a leverage buffer for Global Systemically Important Banks, the operational risk framework and the new output ratio floor. The revised standards will take effect from January 1, 2022 and will be phased in over five years.

    The revisions to the standardized approach to credit risk include, among other things, recalibrating the risk weights for rated exposures to banks, a specific risk weight for exposures to small and medium-sized enterprises, a standalone treatment of exposures to project finance, object finance and commodities finance, more risk-sensitive approaches for exposures for residential and commercial real estate, subordinated debt, equity exposures and unrated exposures to banks. There is also a new standalone treatment for covered bonds.

    The IRB approach for credit risk has been amended by: (i) removing the option to use the advanced IRB approach for certain asset classes, including for exposures to large and mid-sized corporates, banks and other financial institutions and for exposures to equities; (ii) adopting "input" floors; and (iii) providing more specification of parameter estimation practices to reduce risk-weighted asset variability.

    The CVA framework has been revised to enhance its risk sensitivity by taking into account the exposure component of CVA risk. The framework has been made more robust by removing the use of an IRB approach, leaving a standardized approach and a basic approach, which have been recalibrated to align with the revised market risk framework: the standardized approach is based on fair value sensitivities to market risk factors and the basic approach is benchmarked to the standardized approach. In addition, the revised CVA framework allows banks with an aggregate notional amount of uncleared derivatives less than or equal to EUR100 billion to calculate their CVA capital charge as a simple multiplier of its counterparty credit risk charge.

    The operational risk framework revision replaces the existing advanced measurement approach and three standardized approaches with one standardized approach that must be used by all banks. The operational risk capital components will be based on a measure of a bank's income and a measure of a bank's historical losses. There is discretion granted to regulators not to set a bank's capital requirements for operational risk by reference to historical losses. However, all banks will be required to disclose their historical operational risk losses, even if this discretion is exercised.

    The leverage ratio framework introduces a further leverage ratio buffer for G-SIBs, which must be met with Tier 1 capital. The buffer is set at 50% of a G-SIB's risk-weighted higher-loss absorbency requirements. The buffer does not apply to non-G-SIB banks. Capital distribution restraints will be imposed on a G-SIB that fails to meet its leverage ratio buffer requirement. In addition, amendments are made to the leverage ratio exposure measure, including changing the way in which derivatives are reflected in the measure.

    Finally, the Basel III reforms replace the existing Basel II floor with a new output floor ratio based on the revised Basel III standardized approaches. The output floor provides a risk-based backstop that limits the extent to which banks can lower their capital requirements by using internal models. It will not be possible to reduce the capital charge associated with risk-weighted assets to below 72.5% of the charge that would arise under the standardized approach. It is expected that this requirement will become capital limiting for 20% of banks, many of them located in Europe. Banks will be required to disclose their RWAs based on the revised standardized approaches. The specific details of these disclosure requirements will be set out in an upcoming consultation paper. The output floor requirements will be phased in from January 1, 2022 until January 1, 2027. Regulators will have a discretion to apply a transitional cap during the phase-in period.

    The Basel Committee has also decided to change the implementation date for the revised market risk framework, which was published in January 2016, from January 1, 2019 to January 1, 2022. The revised implementation date will allow firms further time to develop their systems. The Basel Committee will also have time to consider certain issues related to the market risk framework and to conduct a review of the calibrations of the standardized and internal model approaches.

    The Basel Committee notes its commitment to review the impact of the Basel III reforms. In particular, it will assess the impact of the Basel III leverage ratio requirements on the provision by banks of clearing services to clients.

    View the full report.

    View the summary of the reforms.

    View the impact assessment.

    View previous versions of the revised areas and related consultation papers.

    View the revised market risk framework.