Basel III

Basel III is an international banking regulation established by the Basel Committee on Banking Supervision (a group of central banks) in response to the 2008 financial crisis. It sets minimum capital ratios, liquidity standards, and leverage limits for banks globally. Banks must hold capital equal to 7–10.5% of risk-weighted assets (depending on the type of capital) and maintain liquid assets covering 30 days of outflows. Basel III dramatically increased capital requirements compared to predecessor Basel II.

Capital ratios and risk-weighted assets

Basel III requires banks to hold capital (equity) equal to a percentage of their assets, adjusted for risk. A bank cannot lend out all deposits; it must hold a cushion. The capital ratio is defined as:

Capital Ratio = Capital / Risk-Weighted Assets

Basel III defines three tiers of capital:

1. Common Equity Tier 1 (CET1) — the strictest form, essentially pure equity. Minimum 4.5% of risk-weighted assets.
2. Tier 1 Capital — CET1 plus some hybrid instruments. Minimum 6% of risk-weighted assets.
3. Total Capital — Tier 1 plus Tier 2 (subordinated debt, loan loss provisions). Minimum 8% of risk-weighted assets.

Risk-weighted assets are calculated by assigning risk weights to assets. A mortgage might be 50% risk-weighted (because mortgages are relatively safe), while a corporate loan might be 100% (riskier). A bank holds less capital against mortgages than corporate loans.

The leverage ratio

Basel III also introduced a leverage ratio (capital divided by total assets, not risk-weighted). The minimum is 3%. This is a backstop to prevent banks from taking on excessive leverage even if risk-weighted measures suggest they can.

The leverage ratio is controversial. Some argue it is too strict (force banks to hold capital against low-risk assets, raising costs). Others argue it is too lenient (3% is still high leverage for other industries).

Liquidity standards: LCR and NSFR

Basel III imposed two liquidity standards. The Liquidity Coverage Ratio (LCR) requires banks to hold high-quality liquid assets (cash, government bonds) sufficient to cover net cash outflows over 30 days of stress. The Net Stable Funding Ratio (NSFR) requires stable funding over a one-year horizon.

These address the problem in 2008: banks had plenty of capital but not enough liquid assets, so they could not survive a run. Liquidity standards force banks to manage their balance sheets to maintain exit liquidity.

Buffers: capital conservation and countercyclical

Basel III adds buffers on top of minimum requirements:

• Capital conservation buffer (2.5%) — banks must hold this extra capital and are restricted on dividends if they fall below it
• Countercyclical buffer (0–2.5%) — regulators can raise this during boom times to dampen credit growth, then lower it during downturns

These buffers are meant to make the system more resilient — banks retain capital during booms when losses seem unlikely, building up a cushion for when losses come.

Basel IV (ongoing)

Banking regulators have continued to refine the rules. “Basel IV” (or “Basel 3.1,” as regulators call it) was finalized in 2017 with tweaks to capital calculations. Implementation has been delayed and contentious, as US regulators debate how strictly to implement international rules.

US implementation

The Federal Reserve and OCC have implemented Basel III through regulations. Large banks must pass annual “stress tests” (CCAR) to prove they meet Basel III ratios under a severe recession scenario. Capital standards are complemented by the Volcker Rule and other post-2008 regulations.

Criticism: too tight or too loose?

Banks argue Basel III is too strict — that high capital requirements raise the cost of credit and reduce lending. Critics of the financial industry argue it is too loose — that 8% capital is still high leverage (only 12x), and that 2008 would not have been prevented by Basel III alone.

Economists debate whether Basel III actually reduces systemic risk or just redistributes it (banks hold capital, move risky assets to unregulated shadows, etc.). Empirical evidence is mixed.

See also