Key Basel III Requirements for Banks and Crypto Assets

Cryptocurrencies are increasingly coming under the purview of regulators worldwide, and it’s clear that specific crypto regulations are just a matter of time. The trend towards tighter regulation can be observed annually, with governments and financial authorities paying closer attention to how cryptocurrencies operate within the broader financial system.

The Basel III requirements, which aim to strengthen regulation, supervision, and risk management within the banking sector, are also influencing the crypto market. Although initially designed for traditional banks, they are beginning to set a precedent that could extend to the crypto industry, especially in terms of capital adequacy, stress testing, and market liquidity risk.

Dive deeper into our comprehensive analysis to understand how Basel III is reshaping the banking world, its pivotal reforms, and the critical decisions it holds for the future of crypto.

What is Basel III?

Basel III is a comprehensive set of reform measures designed to enhance the regulation, supervision, and risk management within the banking sector.

Initiated in response to the financial crisis of 2007-2008, these recommendations were developed by the Basel Committee on Banking Supervision (BCBS) to address deficiencies in financial regulation that were revealed by the crisis.

The BCBS, based in Basel, Switzerland, consists of 45 members from central banks and bank supervisors across 28 jurisdictions.

The roots of Basel III trace back to its predecessors, Basel I and Basel II, which were established in 1988 and 2004, respectively. Basel I introduced credit risk assessment and minimum capital requirements, and Basel II focused on bank capital adequacy, risk management, and market discipline. Meanwhile, Basel III was developed to strengthen the regulation, supervision, and risk management of banks to ensure they could withstand economic and financial stresses, improve risk management, and promote transparency.

This regulatory framework has been adopted by member countries of the BCBS, which include all G20 nations and nearly all OECD countries, making it a global standard for banking regulation.

The implementation of Basel III standards, however, varies across different countries, depending on their specific banking industry structure and regulatory environment, but the core principles are widely adopted to guarantee a level playing field in the global banking sector.

Requirements for banks: new reforms under Basel III

Basel III requirements are structured to enhance the stability and resilience of the global banking system through comprehensive measures divided into key areas: capital, liquidity, large exposures, and special considerations for Systemically Important Banks (SIBs).

Capital

The capital requirements under Basel III are designed to improve both the quality and quantity of capital held by banks. These are:

Higher capital requirements

Basel III raises the minimum common equity tier 1 (CET1) capital ratio from 2% under Basel II to 4.5% of risk-weighted assets (RWAs).

Capital сonservation buffer

Basel III implemented an additional buffer to ensure banks build up capital reserves outside periods of financial stress. Specifically, banks are required to maintain a capital conservation buffer of 2.5%, making the total Common Equity Tier 1 (CET1) requirement 7%.

Countercyclical measures

To protect the banking sector from periods of excessive aggregate credit growth that can lead to a build-up of systemic risk, Basel III includes countercyclical measures, such as the countercyclical capital buffer. It varies between 0% and 2.5% of RWAs, depending on the national regulator’s assessment of credit growth.

Liquidity

Basel 3 requirements introduce two key liquidity ratios to ensure that banks have sufficient liquidity to withstand short-term and long-term stress scenarios:

Liquidity Coverage Ratio (LCR)

To complement the risk-based capital requirements, the framework implements a non-risk-based leverage ratio. This measure requires banks to hold enough high-quality liquid assets to cover their total net cash outflows over a 30-day stress period.

Net Stable Funding Ratio (NSFR)

The NSFR aims to promote more stable funding structures by requiring banks to maintain a stable funding profile in relation to their assets and off-balance sheet activities over a one-year time horizon.

Large exposures

The large exposures framework limits the maximum loss a bank could face in the event of a sudden counterparty failure to a level that does not endanger the bank’s solvency. This includes limits that set caps on the size of exposures banks can have to a single counterparty or groups of connected counterparties.

SIBs

Recognizing the potential for systemic risk posed by the largest and most interconnected banks, Basel III mentions specific provisions for Systemically Important Banks (SIBs), which are classified into two categories:

1. Global Systemically Important Banks (G-SIBs)

Banks whose distress or disorderly failure would cause significant disruptions to the global financial system. G-SIBs are subject to higher loss absorbency requirements and more stringent regulatory oversight.

2. Domestic Systemically Important Banks (D-SIBs)

Banks that are critical to the functioning of a country’s financial system and economy. While the specific requirements for D-SIBs can vary by country, they generally encompass higher capital requirements and enhanced regulatory scrutiny.

What is Basel III Endgame?

In July 2023, U.S. banking regulators announced their intention to introduce a comprehensive proposal for stricter bank capital requirements, known as the “Basel III Endgame.” This initiative seeks to enhance the stability of large banks by overhauling how they manage their capital, which could significantly impact their lending and trading activities.

The new rules will specifically target banks with assets of $100 billion or more, responding to concerns over the adequacy of capital reserves to withstand loan losses during economic downturns. Despite the banking sector’s argument that additional capital requirements are unnecessary and could harm the economy, regulators are pushing forward with the proposal, emphasizing the need for a more resilient banking system.

The “Basel III Endgame” is the culmination of efforts by the Basel Committee on Banking Supervision to implement a set of international banking standards designed to prevent a repeat of the 2007-09 global financial crisis. These standards include a variety of capital, leverage, and liquidity requirements, with the “endgame” focusing on refining capital allocation based on the riskiness of banks’ activities.

Key areas of reform are credit risk, market risk, and operational risk, with a move away from banks’ internal risk models towards more uniform standards. Let’s take a closer look at these reforms.

Credit risk

U.S. regulators plan to prohibit banks from using their internal risk models for calculating capital requirements for lending activities such as mortgages and corporate loans. The authorities will instead enforce uniform modeling standards across major banks.

Market risk

The proposal outlines stricter rules for banks to assess market fluctuations and trading losses, addressing current underestimations of trading risks.

While banks can use regulator-approved internal models, standardized models might be mandated for complex risks, and trading risks must be evaluated at the individual desk level.

Ultimately, this will likely increase capital requirements for banks with significant trading activities.

Operational risk

The Basel III Endgame emphasizes operational risk, targeting losses from unforeseen events like policy failures or external shocks. Regulators want to standardize risk assessment, moving away from internal models to consider a bank’s activities and past losses.

In general, banks have expressed concerns over these reforms, fearing they could lead to disproportionately higher costs and arguing that existing capital levels are sufficient, as demonstrated during the COVID-19 pandemic.

However, regulators, appointed by U.S. President Joe Biden and influenced by recent bank failures, remain committed to stringent enforcement of these new standards.

Basel III requirements and crypto: additions and alterations

In June 2022, the Basel Committee on Banking Supervision proposed a new prudential standard for treating banks’ exposures to crypto assets. The proposal, after undergoing a period of consultation and receiving feedback from stakeholders, was finalized and published in December 2022. It is set to be implemented by January 1, 2025.

The Basel III framework for crypto assets introduces several critical regulatory changes to safeguard the banking sector from the potential risks associated with crypto asset exposures. These changes are:

1. Classification of crypto assets:

• Group 1. Includes tokenized traditional assets and crypto assets with effective stabilization mechanisms. These are subject to capital requirements based on the risk weights of underlying exposures.
• Group 2. Comprises crypto assets that fail to meet the classification conditions, posing additional and higher risks. These are subject to a newly prescribed conservative capital treatment.

2. Infrastructure risk add-on. Initially proposed as a fixed 2.5% add-on for Group 1 crypto assets, it was revised to a flexible model. Authorities can now adjust add-ons based on the infrastructure’s observed weaknesses, encouraging proactive risk management by banks.
3. Redemption risk test and supervision/regulation requirement. For stablecoins to be eligible for inclusion in Group 1, they must pass a redemption risk test and be issued by supervised and regulated entities with robust redemption rights and governance.
4. Group 2 exposure limit. Banks are required to limit their Group 2 crypto asset exposures to 1% of Tier 1 capital. Plus, a new 2% threshold has been introduced, beyond which all Group 2 exposures are subject to the stricter Group 2b capital treatment.
5. Other regulatory requirements. The standard further specifies the application of operational risk, liquidity, leverage ratio, and large exposure guidelines to banks’ exposures to crypto assets, in addition to detailing specific disclosure mandates.

The document also says that the BCBS is committed to rigorously overseeing the impact of the crypto asset standard, recognizing the need for ongoing adjustments and clarifications in response to the fast-evolving market. The committee will continuously collect information from banks, oversee standard implementation, and collaborate with other regulatory bodies.

Key areas for focused review are:

• Exploring statistical methods for identifying low-risk stablecoins
• Assessing the risks of permissionless blockchains for potential inclusion in Group 1
• Evaluating the eligibility of Group 1b crypto assets as collateral
• Scrutinizing the criteria for hedge recognition in Group 2a crypto assets
• Adjusting the exposure limits for Group 2 crypto assets based on market developments

These efforts aim to ensure consistent application of the standard and address new risks, thereby safeguarding the banking sector from the unique challenges posed by crypto assets.

Conclusion

The Basel III requirements for crypto assets provide a detailed framework to help banks, financial institutions, and related businesses effectively manage crypto exposure risks.

Adapting to these evolving standards can be challenging. This is why partnering with experts who can navigate these complexities becomes invaluable.

You can turn to our blockchain consulting services that specialize in demystifying the regulatory environment for our clients, offering tailored advice and solutions that align with the Basel III requirements and beyond.

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