Today, we are back for our fourth and final installment of our spring lunch series recap to discuss an older, yet continually challenging regulation for the hedge fund community: Basel III. Due to its complexity, Basel III continues to pose obstacles for the financial community.
Basel III was introduced in 2005 to address risks within the financial sector. The main goal of this regulation is to enact improved risk management processes for banks and enhance transparency for the banking community. The introduction of Basel III brought about several changes to the industry, mainly concerning capital raising and liquidity. Specifically, the changes concerned:
- The quality, consistency, and transparency of how capital is raised
- How to risk coverage of the capital framework would be strengthened
- Introducing a leverage ratio as a supplementary measure to risk framework
- Reducing procyclicality and promoting countercyclical buffers
- Introducing a Liquidity Coverage ratio for short term liquidity measures and a Net Stable Funding Ratio for long term liquidity measures
Basel III comprises two parts regarding regulatory capital and asset and liability management, which I outline in depth below.
Part One: Regulatory Capital
- Solvency Ratio raised to 7% from 2% (Ratio = Regulatory Capital) / (Risk-Weighted Assets)
- The removal of certain financial instruments as eligible regulatory capital
- The decision to deduct intangibles and deferred tax assets from the Regulatory Capital
Part Two: Asset & Liability Management
- Covers the Liquidity Coverage Ratio (LCR)
- Three levels of assets (1, 2A and 2B) – 1 60%, 2A 50% and 2B <15%
- Covers the Net Stable Funding Ratio (NSFR)
- Long term refers to time longer than one year
- Stable funding includes:
- Equity and any liability maturing after one year
- 90% of retail deposits
- 50% of deposits from non-financial corporate and public entities
- Long-term uses include:
- 5% of long-term sovereign debt or equivalent with 0%-Basel II Standard approach risk-weighting
- 20% of non-financial corporate or covered bonds at least rated AA- with a residual maturity above 1 year
- 50% of non-financial corporate or covered bonds at least rated between A- and A+ with a residual maturity above 1 year
- 50% of loans to non-financial corporates or public sector
- 65% of residential mortgage with a residual maturity above 1 year
- 5% of undrawn credit and liquidity facilities
