Basel regulatory framework
As the global body charged with enhancing banking regulation, supervisory practice, and the risk management of institutions, the Basel Committee on Banking Supervision agrees on and publishes rules concerning the capital, risk management, and liquidity of institutions.
The Basel accords mainly focus on internationally active institutions, without precisely defining what these are. The framework accords known as Basel II and Basel III are relevant for European legislation, and they affect not just internationally active institutions but all institutions, including Pfandbrief banks (see also CRD/CRR, European legislation).
The 1988 accord on capital requirements (Basel I) focused on the minimum capital for institutions in order to limit risks and thus losses in the event of an institution’s insolvency. The minimum capital requirements initially related exclusively to credit risk, which was based on a calculation method that made little distinction as to risks. Later, minimum capital requirements for market risk were also agreed.
Building on Basel I, the 2004 framework accord on the international convergence of capital measurement and capital standards (Basel II) sought to make the minimum capital requirements for banks (Pillar 1) dependent on the amount of risk assumed, strengthen the risk management of institutions and specify basic principles for qualitative banking supervision (Pillar 2), and define various disclosure obligations in order to reinforce market discipline (Pillar 3).
Beginning in 2010, the existing requirements under Basel II were supplemented by new accords, which laid down stricter capital and liquidity rules (known as Basel III) in order to strengthen the resilience of the banking sector against shocks arising from stress situations in the financial sector or the economy. Together with the minimum liquidity requirements, a revised definition of capital and the introduction of additional capital buffers (e.g. capital conservation buffer and countercyclical capital buffer) is at the heart of the first stage of Basel III.
This was followed in the years 2014 to 2016 by an initial framework arrangement for large exposures and for interest-rate risks in the banking book, as well as a fundamental review of the minimum capital requirements for market risk. Finally, in December 2017, a comprehensive set of revised requirements was published with the finalisation of Basel III – also known in the industry as Basel IV because of its significant effects:
- Standardised Approach for credit risk for determining capital requirements
- Internal Ratings-Based Approach (IRB Approach) for determining capital requirements for credit risk
- Approaches for determining capital requirements for credit valuation adjustment (CVA) risk
- Approaches for determining capital requirements for operational risk
- Introduction of an output floor for the purpose of limiting capital relief when using more risk-sensitive internal approaches
Together with the fundamentally revised capital requirements for market risk, the Basel Committee on Banking Supervision envisages that these measures based on COVID-19 should now enter into force one year later starting in 20232 (in some cases, with transitional rules until 2028).
With respect to positions takes by the vdp head office, please see our comments on the revised Standardised Approach for credit risk and the revised IRB Approach, as well as the comments of the German Banking Industry Committee (see also Comments).
Capital requirements: The three-pillar model
The first pillar covers the minimum capital requirements for credit, market, and operational risk. For each of the types of risk, institutions have various risk-measurement processes for determining capital requirements at their disposal: on the one hand, simple, standardised approaches and, on the other, approaches that are more risk-sensitive and based on internal bank measurement processes. The latter may result in lower capital requirements from a risk sensitivity viewpoint, which are nevertheless greatly limited by the output floor.
In addition, a non-risk-sensitive leverage ratio (LR) was introduced in order to prevent individual institutions from building up excessive on- and off-balance sheet leverage and to correct potential errors associated with risk-based capital requirements.
The supervisory framework for large exposures also supplement the risk-based capital requirements in order to protect institutions against high-volume losses as a result of a customer default.
Liquidity coverage ratio (LCR)
The minimum capital requirements are supplemented by minimum liquidity rules. The aim of the minimum liquidity rules is to ensure that institutions have sufficient liquidity at all times. The liquidity coverage ratio (LCR) helps to ensure short-term liquidity by requiring an institution to maintain a stock of high-quality liquid assets sufficient to cover its liquidity needs for 30 calendar days in a severe liquidity stress scenario by selling them on private capital markets.
Net stable funding ratio (NSFR)
In addition, the net stable funding ratio (NSFR) is designed to ensure the institution’s longer-term liquidity. This is accomplished by way of a balanced maturity structure for the institution’s assets and liabilities. For this purpose, the available stable funding (weighted liabilities) must exceed the required stable funding (weighted assets, including off-balance sheet items).
The second pillar supplements the quantitative minimum capital requirements in Pillar 1 and the minimum liquidity rules by including both qualitative elements and other quantitative aspects for risks not taken into consideration by Pillar 1, such as interest-rate risk in the non-trading book. On the one hand, the Pillar 2 requirements are directed at institutions, which are required to establish, on the basis of an internal process, a level of capital (Internal Capital Adequacy Assessment Process, ICAAP) and a level of liquidity (Internal Liquidity Adequacy Assessment Process, ILAAP) commensurate with their risk profile. This is also the aim of the principles for effective risk data aggregation and risk reporting (BCBS 239).
On the other hand, supervisory authorities have the task of evaluating how well institutions are assessing their capital and liquidity levels in relation to their risks and intervening if necessary (such as by determining additional own funds requirements specifically for an institution). They do so by means of the Supervisory Review and Evaluation Process (SREP), in which they identify an institution’s overall risk exposure and the key factors influencing its risk situation and prudentially evaluate them (see also Supervisory practice).
Supplementing Pillars 1 and 2, the third pillar reinforces market discipline. The expectation is that institutions will be disciplined by the fear of changes to the market prices of their issued securities. Thus, disclosure obligations are especially important. They enable market participants to obtain information about capital, liquidity, risk exposures, and risk assessment processes and evaluate whether capital and liquidity are adequate. This allows market discipline to be reinforced.