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 internationally active banks.
Irrespective of the lack of a formal definition of internationally active banks, the Basel accords are relevant for European legislation, and they affect not just internationally active banks but all institutions, including Pfandbrief banks and real estate financiers (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. However, both loans fully secured by mortgage on residential property and sovereign exposures, such as central governments and central banks, public-sector entities and multilateral development banks, have been privileged from the outset by lower capital requirements (i.e. lower risk weights) in a risk-adequate manner. At the end of 1995, 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) more dependent on the amount of risk assumed (e.g. introduction of an internal ratings based approach, IRBA),
- 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).
With regard to Pillar 1, in addition to residential real estate financing, a privileged capital requirement was also introduced in the standard approach for credit risk for claims secured by commercial real estate, provided that the commercial real estate is located in well-developed and long-established markets. This applies in particular if only very small losses stemming from commercial real estate lending in a market in each year (max. 0.3 percent). This can be demonstrated for Germany since 1988. The publicly available data on losses per outstanding loan are as follows:
Beginning in 2010, following experience with the significant impact of the financial crisis on many institutions, the existing requirements under Basel II were supplemented by new accords, which laid down stricter capital and liquidity rules (known as Basel III). The aim was 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 (capital conservation buffer, countercyclical capital buffer, capital buffers for systemically important banks) are at the heart of the first stage of Basel III.
This was followed in the years 2014 to 2016 by initial frameworks 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 (FRTB). Finally, in December 2017, a comprehensive set of other revised requirements was published with the reform of Basel III – also known in the industry as Basel IV because of its significant effects:
- Standardised approach for credit risk and internal ratings-based approach (IRBA) 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 potential capital relief when using more risk-sensitive internal approaches (IRBA etc.)
According to the Basel requirements on the output floor, the capital floor is to be determined on the basis of the standard approaches for determining risk-weighted assets (RWA) or RWA equivalents. 72.5 percent of the sum of these RWA represents the lower limit for the output floor RWA (floored RWA).
The output floor RWA (floored RWA) are to be used to determine the capital floor. According to the Basel regulations on the output floor of December 2017, the capital floor results from the sum of the following capital requirements (multiplied by the floored RWA):
- 8 percent total capital ratio
- 2,5 percent capital conservation buffer (CCB)
- Bank-specific countercyclical capital buffer (CCyB)
- Capital buffer for global systemically important banks (G-SIB)
Along with this capital floor, the competent supervisory authority has the option to require or expect capital according to Basel Pillar 2 and to require a capital buffer for domestic systemically important banks. The methodology for determining this capital is to be designed jurisdiction-specifically on the basis of the generally formulated Basel principles.
Together with the fundamentally revised capital requirements for market risk, the Basel Committee on Banking Supervision envisages that the reform of Basel III due to COVID-19 should now enter into force one year later starting in 2023 (in some cases, with transitional rules until and including 2027).
With respect to positions takes by the vdp head office, please see our comments on the commission’s consultation on EU implementation of the reform of Basel III, the revised standardised approach for credit risk and the revised IRBA, as well as the corresponding comments of the German Banking Industry Committee (see also Comments).
Capital requirements: The three pillar approach
The first pillar covers the risk-based minimum capital requirements for credit, market, counterparty 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, relatively simple and standardised approaches and, on the other, approaches that are more risk-sensitive and based on internal bank measurement processes. The latter regularly result in lower capital requirements from a risk sensitivity viewpoint, which can, nevertheless, be 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 cushion potential inadequacies 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 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. These high-quality liquid assets may also include covered bonds such as Pfandbriefe.
Net stable funding ratio (NSFR)
In addition, the 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.
The Pillar 2 requirements are directed at institutions on the one hand and supervisory authorities on the other. Institutions 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).
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) and by supervisory stress tests, 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 is intended to reinforce market discipline. The expectation is that institutions will be disciplined by the fear of changes to the market prices of their issued securities in case of negative information (investor reaction). Other stakeholders (e.g. institutional clients) should also be informed by Pillar III. 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. However, for institutions that are not active in the capital market these requirements are a heavy bureaucratic burden.