Basel III Endgame sounds more like an ominously titled spy thriller sequel than the last stage of U.S. regulators' implementation of reforms meant to ensure the stability of the banking system. However, the banking industry has depicted the reforms, which largely call for the country's largest banks to put aside more capital in reserve to weather financial storms, as a threat to the American economy. In a lobbying blitz Basel III's supporters have called "unprecedented," the banking lobby has amassed an army of lobbyists in Washington D.C. and poured millions into a media campaign to denounce the proposed regulations.
Key Takeaways
- Basel III is an international regulatory accord designed to improve the regulation, supervision, and risk management of the banking sector.
- A consortium of central banks from 28 countries devised Basel III in 2009, mainly in response to the financial crisis of 2007–2008 and the subsequent economic recession.
- Basel III is part of an evolving framework that adapts to changes in national economies and the financial landscape.
- Basel III Endgame, the name given to the final implementation begun in 2017, is set to end in 2024, with the regulations to take effect in mid-2025.
Understanding Basel III
The regulations date to the wake of the 2007-to-2009 financial crisis, when financial watchdogs worldwide met to discuss ways to avoid a similar catastrophe. In 2009, they agreed through the international Basel Committee on Banking Supervision to develop minimum capital, leverage, and liquidity requirements to ensure major banks could survive another upheaval. The U.S. version of the new rules, designed by regulators at the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, was sent out for comments in mid-2023.
Lobbies like the Bank Policy Institute have taken to the airwaves and online, warning that the suggested regulations, which, as of July 2023, targeted only about 37 U.S. banks with holdings of $100 billion in assets or more, would put young families' dreams of homeownership and small businesses' expansion plans at risk. The banks claim the reforms would not make them any more stable and would have knock-on effects on their ability to lend funds to those with less credit, including minorities who have historically faced problems obtaining credit from American financial institutions.
Soon after the end of the commentary period in early 2024, federal regulators were already backtracking on their initial proposals from 2023, which made the rules defenders furious. "When the heat was on last year, you talked a lot about getting tougher on the banks," U.S. Senator Elizabeth Warren told Jerome Powell, chair of the Federal Reserve, during a March 7, 2024, Congressional hearing. "Now the giant banks are unhappy about that, and you've gone weak-kneed."
The final regulations are set to be released with enough time to take effect on July 1, 2025. At that point, a three-year phase-in of the regulations would begin. But what exactly does Basel III entail, and why has it led to such heated rhetoric in the financial world? Below, we go through what's in the reforms, how they would impact banks, and why what happens to Basel III Endgame is important for everyday investors.
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A Deeper Dive Into Basel III
Basel III was rolled out by the Basel Committee on Banking Supervision, a consortium of central banks from 28 countries based in Basel, Switzerland, shortly after the financial crisis of 2007–2008. Many banks were overleveraged and undercapitalized during this period despite earlier reforms called Basel I and Basel II.
Also called theThird Basel Accord, Basel III is a continuing effort to strengthen an international banking framework that began in 1975. The Basel I and Basel II accords aimed at improving the banking system’s ability to deal with financial stress, improve risk management, and promote transparency. The first Basel Accords were introduced in 1988 and came on the heels of that decade’s debt crises in Latin America. Basel I required banks to hold 8% of their risk-weighted assets as a buffer against potential losses. This was a significant step in ensuring that banks had enough financial strength to withstand losses and didn’t jeopardize the rest of the financial system.
Following Basel I and the many changes in the financial markets in the dot-com era, further measures were deemed necessary, leading to Basel II in 2004. Basel II introduced more sophisticated models for calculating risk, expanding beyond credit risk to account for operational and market risks (losses due to changes in market prices). Basel II also encouraged banks to build their own internal models to better assess the specific risks they faced.
It didn’t take long, though, before the approach of Basel II already looked outdated, given the banking storms of the 2007–2008 period. The transition from Basel II to Basel III would mark a significant shift in the global approach to banking regulation. While Basel II focused primarily on the amount of capital the banks held and how they managed risk, Basel III included new rules on liquidity, leverage, and systemic risk factors.
Many parts of Basel III are already in place worldwide, including the U.S. However, the final changes, called Basel III Endgame and agreed upon in 2017, have been delayed for years by the COVID-19 pandemic and banks calling for more time to adjust to and lobby against the new regulations. Deadlines have come and gone, with mid-2025 the latest date for when the rules are supposed to go into effect in the U.S., which means announcing them months earlier to provide regulators, banks, and other stakeholders the time needed to prepare to meet the new standards. Banks would start using the rules on July 1, 2025, with the goal of having them fully in place three years later.
Basel III Endgame includes updates to how banks calculate the risk of people not paying back their loans, how they use their own internal models to determine how much money they need to keep in reserve, and how they should handle operational risks like fraud or system failures. Let’s go through each of these areas before turning to what this all means for everyday investors.
Minimum Capital Requirements Under Basel III
Before starting, it’s worth reviewing that banks have two main silos of capital to work with. Tier 1 is a bank’s core capital, equity, and reserves that appear on the bank’s financial statements. If a bank experiences significant losses, Tier 1 capital is what can allow it to weather stress and keep its doors open. By contrast, Tier 2 refers to a bank’s supplementary capital, such as undisclosed reserves and unsecured subordinated debt instruments. Tier 1 capital is more liquid and more secure than Tier 2 capital.
Under the proposed Basel III Endgame, banks with over $100 billion in assets would have to keep more money in their reserves to cover potential losses. The new rules would allow banks to calculate the riskiness of assets like loans and investments in two different ways. They’d have to use whichever method puts aside more capital to err on the side of safety and stability.
An important type of capital banks would need more of is called common equity Tier 1 (CET1). This includes the money banks get when they issue stock and the profits they hold onto instead of paying out to shareholders. Big banks would also have to keep a minimum level of capital as a proportion of all their assets (including things that aren’t on their main balance sheet), not just the risky ones. If the economy is doing well, regulators could make banks hold even more capital to prepare for a possible downturn. Banks would also need a minimum of 6% of their risky assets in Tier 1 capital, including CET1 and a few other super-safe investments. The minimum for total capital (Tier 1 plus Tier 2, which is slightly riskier) would stay at 8%.
So while the total capital ratio (Tier 1 + Tier 2) remains at 8%, as it’s been since Basel I, the composition of what banks can use as that capital is changing, with a greater emphasis on higher-quality forms of capital since it’s also changing what it’s a percentage of, removing any consideration of riskier capital, Tier 3, from the calculation. That would mean the way banks calculate their risk-weighted assets (the denominator or bottom figure in the capital ratios) would change.
Thus, while the 8% figure might look the same, the changes to the capital ratios' numerator and denominator and new buffer requirements mean that Basel III Endgame would increase capital requirements for the banks targeted by these regulations. Estimates have varied, with the higher ones coming from the banking lobby, but the biggest banks would need to increase the amount of capital they have on hand by as much as 15% to 20% over what they keep in reserve now.
Capital Buffers To Weather Financial Storms
Basel III introduces new capital buffer requirements that banks must maintain above the minimum capital ratios. These buffers are designed to ensure that banks build up capital reserves during good times that they can draw down during economic and financial stress periods.
- Capital conservation buffer (CCB): The proposal requires banks to maintain a CCB of 2.5% of risk-weighted assets with only CET1 capital. This buffer is in addition to the minimum CET1 ratio of 4.5%, effectively raising the CET1 requirement to 7%. Banks that dip into their CCB face restrictions on dividend payouts, share buybacks, and discretionary bonus payments to ensure that they have this on hand.
- Countercyclical capital buffer (CCyB): Regulators can require banks to hold additional capital during periods of excessive credit growth. If triggered, the proposal would apply the CCyB to all banks with $100 billion or more in assets. The CCyB can range from 0% to 2.5% of risk-weighted assets and is intended to be released during times of stress to help banks continue lending. Countercyclical capital buffers must also consist entirely of Tier 1 assets.
- Global systemically important bank (G-SIB) surcharge: The proposal keeps in place a risk-based capital surcharge for American G-SIBs. This extra capital buffer, ranging from 1% to 3.5% of risk-weighted assets, is designed to cut the risks these large, interconnected banks pose to the financial system.
Leverage and Liquidity Measures
Basel III also introduced new leverage and liquidity requirements to protect against excessive and risky lending while ensuring that banks have enough liquidity during periods of financial stress. In particular, it sets a higher leverage ratio for G-SIBs. The ratio is Tier 1 capital divided by the bank’s total assets, with a minimum ratio requirement of 3%.
In addition, Basel III has new liquidity rules. A liquidity coverage ratio requires that banks hold a “sufficient reserve of high-quality liquid assets (HQLA) to allow them to survive a period of significant liquidity stress lasting 30 calendar days.” HQLA includes cash, central bank reserves, and certain government securities that can be easily converted to cash with little or no loss of value.
Another liquidity-related provision is the net stable funding (NSF) ratio, which compares the bank’s “available stable funding” (essentially capital and liabilities with a time horizon of more than one year) with the amount of stable funding that it must hold based on the liquidity, outstanding maturities, and risk level of its assets. The bank’s NSF ratio must be at least 100%. The aim is to create “incentives for banks to fund their activities with more stable sources of funding on an ongoing basis” rather than load up their balance sheets with “relatively cheap and abundant short-term wholesale funding.”
Why This Matters For Everyday Investors
While the complexities of bank capital regulations may seem far removed from the everyday concerns of retail investors, the Basel III Endgame proposal has important implications for the broader economy and financial markets. Here are some of them:
- Confidence in the financial system: A more resilient banking system is better positioned to continue lending during economic downturns, which could help mitigate the severity and duration of recessions. This increased confidence could contribute to more stable financial markets, which benefits all investors.
- Economic growth: Banks play a vital role in supporting economic growth by lending to businesses and consumers. However, critics of Basel III Endgame argue that the higher capital requirements would lead some banks to cut their lending activities, slowing economic growth in the short term. The thinking goes that they would need to keep more of their capital on hand, and thus, their lending would slow. Proponents of the plan, however, have pointed to studies that show that banks might lend more with more of a cushion to backstop their lending activities, the same way having more savings might make you less reluctant to lend to a family member. Whether up or down, others say any influence would be modest at best.
- Financial stability: The Basel III Endgame rules aim to make the banking system more resilient to economic shocks by requiring banks to hold more high-quality capital and maintain stronger liquidity positions. A durable banking system is crucial for the smooth functioning of the economy, ensuring that businesses and individuals have access to credit and financial services. For investors, a more stable financial system reduces the risk of severe market disruptions that would impact their portfolios.
While the Basel III Endgame rules primarily aim to strengthen the banking system, their effects would ripple through the entire economy.
What Impact Would Basel III Have on the Profits of the Big Banks?
Given the millions the big banks are spending on commercials opposing Basel III Endgame, it's reasonable to assume they think it will hurt their bottom line. Higher capital requirements can affect bank profitability, as banks may need more capital in reserve instead of using it to generate returns. This could, in turn, influence bank stock valuations and dividend payouts, which would be scrutinized should they not meet some of the capital requirements. However, better-capitalized banks may be viewed as safer investments, which could attract more investors over the long term, and some research has suggested they could do better financially, too.
What Affect Would Basel III Have on Small and Medium-Sized Banks?
While Basel III primarily targets very large, internationally active banks, critics charge that its regulations would also affect small and medium-sized banks. This has been the focus of much of the advertising campaign around the issue. These banks may face increased operational costs because the banks that they work with would face higher costs. However, federal regulators have said this isn't the case, and the framework allows for some flexibility, recognizing the different risk profiles and business models of smaller banks.
When Does Basel III Go Into Effect?
While we can report the deadlines U.S. regulators have given, a "wait and see" approach might be in order. Since the Basel III Endgame process began, bank requests for more time to digest and comment on the plans, COVID-19, and shifts in the post-pandemic economy have all pushed back the deadlines. As it stands now, the regulations should start taking effect July 1, 2025, followed by a three-year phase-in period to give banks time to transition to the new rules. While previous deadlines have come and gone, the commentary period is over, which offers U.S. federal regulators more room to maneuver in going ahead with implementation.
The Bottom Line
The global financial crisis of 2007-2008 exposed critical weaknesses in the banking system, highlighting the need for more robust market protections. Enter Basel III, a comprehensive set of international banking reforms designed to fortify banks against future shocks. As the 2028 deadline for full implementation approaches, stakeholders continue to debate its requirements and what's needed to safeguard the economy against the systemic risk destabilized banks have presented in past crises.
