Basel 3: Pillars in detail

WHAT IS BASEL III ?

The Basel III accord is a set of financial reforms that was developed by the Basel Committee on Banking Supervision (BCBS), with the aim  to promote stability in the international financial system & to reduce damage to the economy by banks that take on excess risk.

The Basel III norms seek to improve the ability of banks to handle stress. The norms specify leverage ratios and capital requirements to regulate the working of banks.

3 PILLARS OF BASEL III

The Basel III Guidelines are based upon 3 very important aspects which are called 3 pillars of the Basel II. These 3 pillars are Minimum Capital Requirement, Supervisory review Process and Market Discipline.

1. FIRST PILLAR : MINIMUM CAPITAL REQUIREMENT

It defines the minimum capital requirements to cover credit, market and operational risks, the eligible capital instruments, and the rules for calculating RWA (Risk Weighed Assets). ,The firms must calculate minimum regulatory capital for credit, market and operational risk. Regulatory capital is calculated using the minimum capital adequacy ratio (CAR) which determines the minimum capital required to cover unexpected losses. The minimum CAR is defined as follows :-

CAR = Tier 1 Capital + Tier 2 Capital / Risk Weighted Assets

As of 2015, the Tier 1 capital requirement increased from 4% in Basel II to 6% in Basel III. The 6% includes 4.5% of Common Equity Tier 1 and an extra 1.5% of additional Tier 1 capital.

2. SECOND PILLAR : SUPERVISORY REVIEW PROCESS

The second pillar i.e. Supervisory Review Process is basically intended to ensure that the banks have adequate capital to support all the risks associated in their businesses.

It states that the credit institutions and investment firms must have an internal capital adequacy assessment process (ICAAP) and that national competent authorities must evaluate each credit institution’s and investment firm’s overall risk profile as well as its risk management and internal control processes.

3. THIRD PILLAR : MARKET DISCIPLINE AND DISCLOSURE

The third pillar was introduced to complement the first and second pillar. It is basically a discipline followed by the bank such as disclosing its capital structure, tier-I and Tier –II Capital and approaches to assess the capital adequacy.

Disclosure requirements include:

  • Describing capital instruments, the bank’s approach to assessing capital adequacy, a breakdown of eligible capital and capital requirements for credit, market and operational risk
  • For each risk exposure and risk assessment, a description of the policies, strategies, methods, processes, and responsibilities within the bank
  • A breakdown of exposures, outstandings , past losses, capital requirements and other data depending on the risk and approach taken.

 

Thus, in a nutshell, Basel III is an internationally agreed set of measures developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09 with the objective to enhance the banking regulatory framework.

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