3 Basel Capital and Liquidity

Standards for Deposit Takers

I. Introduction the Basel Capital Accord provides the foundation for

3.1 This chapter discusses prudential standards the national capital adequacy regime. They also need
relating to capital and liquidity developed by the to identify whether their jurisdiction has exercised
Basel Committee on Banking Supervision (BCBS)— any of the many elements of national discretion, and
the international standard setter for banks—which if there are any national variations from the relevant
are relevant to compiling FSIs.1 An overview of the Basel regime (other than the elements of express
concepts and key terminology is provided, but much national discretion).
of the technical detail, which will not in the normal
course be required by compilers, has been omitted. II. Evolution of the Basel Capital Accord
Compilers requiring additional detail are referred to 3.4 There were three novel elements to the origi-
the publications of the BCBS.2 nal Basel Capital Accord. Prior to 1988, there were
3.2 International standards are not themselves no agreed international standards with respect to
binding or enforceable, but rather are implemented, deposit takers, and national approaches to capi-
on a voluntary basis, by national authorities. Compil- tal adequacy were not linked to the riskiness of
ers will rely on national definitions and standards for individual institutions. The Accord (i) introduced
capital, liquidity, leverage and large exposures related commonly accepted definitions of the elements of
series, drawing on supervisory data rather than them- regulatory capital; (ii) linked capital requirements to
selves calculating the various elements of Basel Com- risk through the introduction of risk weights—factors
mittee-prescribed methodology. approximating risk applied to the assets of the bank
to determine required capital; and (iii) established a
3.3 Despite the expected reliance on supervisory minimum capital requirement of 8 percent of risk-
data, it is important for compilers to have a broad weighted assets for internationally active banks,
understanding of the Basel concepts and principles which soon became a de facto standard for almost all
related to capital and liquidity. Compilers need to be banks through its widespread adoption by national
able to document in the metadata which version of authorities.
3.5 The Basel I capital requirement was to be met
1
The Islamic Financial Services Board (IFSB) is the international by Tier 1 capital—the most permanent and loss absorb-
standard setter for institutions offering Islamic financial ing instruments; and Tier 2 capital—instruments with
services. ISFB 15, Revised Capital Adequacy for Institutions some shortcomings with respect to the key features of
Offering Islamic Financial Services, establishes capital adequacy
standards, which, with differences required for Islamic finance, capital—to a limit of 50 percent of total capital.
parallel the standards of the Basel Committee. IFSB Guidance
Note 6 addresses the application of the Basel III liquidity ratios,
3.6 The 1996 Amendment to Incorporate Market
LCR and NSFR, to institutions offering Islamic financial services. Risks partially addressed one of the early criticisms
2
Key publications include (i) International Convergence of Capital of the original Accord—banks are exposed to many
Measurement and Capital Standards (1988), and Amendment to
the Capital Accord to Incorporate Market Risks (1996), collectively risks, but Basel I originally considered only credit risk.
referred to as Basel I; (ii) International Convergence of Capital To maintain consistency with the original approach,
Measurement and Capital Standards: A Revised Framework (2004), the calculation of market risk exposure was expressed
commonly referred to as Basel II; (iii) Basel III: A Global Regulatory
Framework for More Resilient Banks and Banking Systems (2010); in the form of a risk-weighted asset equivalent. A new
and (iv) Basel III: Finalising Post-Crisis Reforms (2017). element of capital, Tier 3, was introduced at national

©International Monetary Fund. Not for Redistribution

18 Financial Soundness Indicators Compilation Guide

discretion, with use limited solely to supporting mar- 3.10 In the immediate aftermath of the global
ket risks.3 financial crisis, Enhancements to the Basel II Frame‑
3.7 Basel II, while retaining the original definitions work (2009), often called Basel II.5, addressed some
of capital and 8 percent minimum, more thoroughly issues that had proven particularly problematic.
addressed the criticism that Basel I focused on only Requirements for retention of a portion of the credit
one (two after 1996) of the many risks faced by banks. risk for securitized assets or application of penal risk
It also responded to criticisms that the risk weightings weights ensured that banks originating asset-backed
were insufficiently granular, not distinguishing, for securities retained an interest in the credit risk of the
example, between the risk of an AAA-rated corporate underlying assets. More stringent requirements were
exposure and a CCC-rated (one notch above default) introduced to ensure that assets securitized or sold
exposure—each was weighted at 100 percent. truly had a “clean break” from the bank before the
assets were removed from the bank’s risk-weighted
3.8 Basel II also reflected feedback from large and assets for regulatory purposes. Additional capital
complex banks, which indicated that the risk weights charges were introduced for some elements of market
and capital required by Basel I bore little resemblance risk, and the advanced method of calculation of mar-
to how risks were internally assessed, and capital allo- ket risk capital charges was revised to require consid-
cated in managing risk in the bank. In response, Basel II eration of stress scenarios.
introduced the advanced measurement approaches,
permitting the use of banks’ internal models, sub- 3.11 Basel III (2010) was a more far-reaching
ject to supervisory approval, in the determination of response to the lessons of the crisis, requiring banks
capital requirements for credit and operational risks.4 to hold more, higher quality capital (Figure 3.1), intro-
Allowing the use of models aligned capital more ducing a leverage ratio and two new liquidity ratios.
closely with complex banks’ actual risk management While the original 8 percent capital adequacy limit
practices, while the Basel II Standardized Approach from Basel I and II was retained, effectively the mini-
introduced additional granularity for smaller or less mum capital requirement became 10.5 percent of risk-
complex banks by using external credit ratings to fur- weighted assets through the introduction of the capital
ther differentiate the risk of credit exposures. conservation buffer (Table 3.1). In addition, other capi-
tal buffers can result in higher minimum requirements
3.9 Basel II required banks to hold capital against for the system overall, and for individual banks. The
three “Pillar 1” risks—credit, market and operational countercyclical capital buffer is a Basel III macropru-
risks, and introduced requirements for banks to iden- dential tool, which can be used by authorities to require
tify other risk exposures and capital requirements in banks to hold additional capital in a period of increas-
“Pillar 2.” The Pillar 2 concept requires banks, whether ing risks. Higher minimum capital requirements for
using the standardized or advanced approaches, to
undertake an internal capital adequacy assessment
process (ICAAP). This requires the identification of Figure 3.1 Basel Capital Requirements
all material risks faced by the bank, and the allocation
of capital against those risks.
2.5%

2.0% Conservation Buffer

Tier 2
3
Tier 3 capital was eliminated in Basel III. Few countries adopted 4.0%
Additional Tier 1

Tier 3 capital as part of their national frameworks, and the national

1.5% Equity or other
Common equity
discretion to allow Tier 3 capital no longer exists. Compilers
generally should not require details of Tier 3 capital, so it is excluded 2.0%
from this discussion. Compilers requiring more information on 4.5%
Tier 3 capital should consult their national supervisory standards
and BCBS Amendment to the Capital Accord to Incorporate Market 2.0%

Risks (1996).
4
Use of internal models for market risk had been introduced in Basel I and II Basel III

Amendment to the Capital Accord to Incorporate Market Risks

Source: IMF and BCBS.
(1996).

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 Basel Capital and Liquidity Standards for Deposit Takers 19

Table 3.1 Basel III Capital Ratios (percent of risk-weighted assets)

CET1 Tier 1 Capital Total Capital

Minimum 4.5 6 8
Capital conservation buffer 2.5 2.5 2.5
Minimum plus capital conservation buffer 7 8.5 10.5

Source: BCBS (2011).

Note: CET1 = Common Equity Tier 1.

large and complex banks result from the application Risk Assessment providing an alternative to the use of
of buffers for globally and domestically systemically external credit ratings in risk weightings; (iii) constraints
important banks. on the use of internal models intended to reduce vari-
3.12 Basel III introduced a Common Equity Tier 1 ability in risk-weighted asset calculations across banks;
(CET1) capital requirement of 4.5 percent of risk- (iv) an output floor for internal model calculation of
weighted assets, which is effectively 7 percent since capital for credit risk of 72.5 percent of the requirement
the 2.5 percent capital conservation buffer must be determined using the standardized approach; and (v) a
met with CET1. This, plus the requirement for Tier 1 single new method for calculating operational risk capi-
capital of at least 6 percent of risk-weighted assets, tal charges that replaces all previous options.
increased the minimum capital available to absorb 3.15 Annex 3.1 summarizes key aspects of Basel I,
losses on a going-concern basis. To ensure going II, and III.
concern loss absorption, instruments qualifying as
Additional Tier 1 (AT1) capital must be subject to
III. Concepts and Terminology
write-down or conversion to common equity. This
meant that some hybrid instruments previously quali- Regulatory Capital
fying at Tier 1 capital were no longer eligible, requir- 3.16 Capital is similar to, but not the same as, the
ing banks to raise more high-quality capital. accounting concept of equity. Capital represents a buf-
3.13 Basel III introduced for the first time agreed fer between the value of banks’ liabilities and assets,
international standards for liquidity. Reflecting that similar to the accounting definition of equity as the
banks and their supervisors had paid insufficient difference between the value of assets and liabilities.
attention to liquidity risk during the long period of From a supervisory perspective, the purpose of capi-
benign market conditions preceding the crisis, the tal is to absorb unexpected losses so that the providers
stress-scenario- based liquidity coverage ratio (LCR) of banks’ liabilities—commonly depositors—will be
and net stable funding ratio (NSFR) require banks repaid in full even if the providers of capital—owners
not only to hold higher levels of high quality liquid and subordinated debt holders—incur losses.
assets (HQLA), but also require increased focus on 3.17 Regulatory capital differs from accounting
liquidity risk management. At minimum, calcula- equity because of the supervisory focus on absorb-
tion of the LCR and NSFR requires banks to apply ing losses. Certain accounting liabilities may be loss
liquidity stress scenarios to their balances sheets and absorbing, for example, debt which is subordinated to
requires supervisory review of banks’ application of the claims of other creditors (including depositors),
these stress-tests. These liquidity ratios are discussed so liabilities meeting specific criteria are included in
in more detail in paragraphs 3.49–3.55. regulatory capital.
3.14 Basel III: Finalisation of Post Crisis Reforms 3.18 The distinguishing elements of regulatory cap-
(2017) is in some ways even more far-reaching than the ital are its permanence, its freedom from fixed charges
original 2010 Basel III reforms. Key elements are (i) a against income, and its ability to absorb losses. The
far more granular approach to credit risk weights in the highest quality capital, common equity, exists for the
standardized approach; (ii) a new Standardized Credit life of the bank unless repurchased at the discretion of

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20 Financial Soundness Indicators Compilation Guide

the bank, receives dividends only on a discretionary 3.23 The original Basel Accord defined two tiers of
basis, and ranks last in the priority of claims and thus capital; Tier 1, comprising the highest quality capital; and
has the highest loss absorption capacity. Tier 2, comprising instruments with some, but not all, of
3.19 Other capital instruments generally are deficient the characteristics of capital discussed earlier. The ele-
with respect to one or more of these key qualities. For ments of Tier 1 and Tier 2 capital remained unchanged
example, subordinated debt must have a minimum term in Basel II. Despite modifications in Basel III, the two tier
to maturity of five years to qualify as capital. It is not per- approach remains central to the Basel standard.
manent, and as a debt instrument has a contractually 3.24 Under Basel I and II, total regulatory capital
agreed interest rate and thus has a fixed charge against can be expressed as:
income. It ranks behind other creditors, and, while not
subject to loss while the bank continues in normal oper- (Tier 1 capital – goodwill) + Tier 2 capital –
ation, will absorb losses on a gone concern basis. adjustments.
3.20 The value of some assets is deducted from reg-
Regulatory adjustments are deductions from capital,
ulatory capital. This is because intangible assets such
which except for goodwill, are deducted from total
as goodwill, and deferred tax assets, which only have
capital in Basel I, and 50 percent from Tier 1 and 50
value to a profit-making bank, are normally written-
percent from Tier 2 capital in Basel II.
off—they are completely worthless—when a bank is
liquidated. The value of these assets is deducted from 3.25 Under Basel III, total regulatory capital is still
capital so that the amount of capital recognized for the sum of Tier 1 plus Tier 2 capital, less adjustments;
regulatory purposes has already been reduced by the however, all regulatory adjustments are deducted
losses expected in liquidation from the write-off of from their respective components. Basel III regula-
intangible and other specified types of asset. tory capital can be expressed as:
3.21 While there are many specific and technical
requirements, in general, regulatory capital (i) includes (CET 1 capital – adjustments) + (AT 1 – adjustments) +
all elements of accounting equity; (ii) includes liabil- (Tier 2 capital – adjustments)
ity instruments meeting prescribed criteria to ensure
3.26 Tier 1 capital (Basel I definition continued
their ability to absorb losses either on a going concern
in Basel II) consists of equity capital and disclosed
basis or in liquidation (gone concern basis); and (iii)
reserves that are considered freely available to meet
is reduced by the value of assets likely to be worthless
claims against the bank. It comprises paid‑up shares
in liquidation.
and common stock-issued and fully paid ordinary
3.22 To prevent the double counting of capital, shares/common stock and perpetual noncumulative
capital requirements should be applied on a consoli- preference shares—and disclosed reserves created or
dated basis. Intra-group positions are eliminated in an increased by appropriations of retained earnings or
accounting consolidation, so capital in subsidiaries cre- other surplus. The latter include, among others, share
ated through the parent bank’s ownership of its equity premiums, retained profit, general reserves, and legal
(and possibly qualifying debt instruments) is elimi- reserves, and are considered to be freely and immedi-
nated. The amount of any investment in a subsidiary ately available to meet claims against the bank.6 Tier 1
which is not consolidated with the accounts of the par- capital excludes revaluation reserves and cumulative
ent should be deducted from the parent bank’s capital.5 preference shares.

6
Tier 1 capital may also include general funds, such as funds for
5
While consolidation of the accounts of the parent and its general banking risk, subject to four criteria: (1) allocations to
subsidiaries is the usual accounting treatment, supervisors the funds must be made out of post‑tax retained earnings or out
generally require that the accounts of banking and insurance of pre‑tax earnings adjusted for all potential tax liabilities; (2)
entities not be consolidated. This is because the banking and the funds and movements into or out of them must be disclosed
insurance businesses are so different that neither banking nor separately in the bank’s published accounts; (3) the funds must be
insurance prudential standards and supervisory analysis can available to a bank to meet losses for unrestricted and immediate
be meaningfully applied to accounts consolidating material use as soon as they occur; and (4) losses cannot be charged directly
amounts of the two types of business. to the funds but must be taken through the profit and loss account.

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 Basel Capital and Liquidity Standards for Deposit Takers 21

3.27 CET1 capital (Basel III definition) consists a minimum original fixed term of maturity of more
of the sum of common shares, retained earnings, than five years and limited‑life redeemable preference
accumulated other comprehensive income and other shares. Tier 2 capital and subordinated debt cannot
disclosed reserves, and common shares issued by sub- exceed 100 percent and 50 percent, respectively, of
sidiaries of the bank that are consolidated with the Tier 1 capital.
bank and held by third parties that meet the criteria 3.30 Tier 2 capital (Basel III definition) consists of
for inclusion in CET1, less regulatory adjustments. the sum of: (1) unsecured subordinated debt with a
3.28 AT1 capital (Basel III definition) consists of minimum original maturity of at least five years and
subordinated instruments with no maturity and nei- limited‑life redeemable preference shares; (2) stock
ther secured nor covered by a guarantee of the issuer. surplus resulting from the issuance of instruments
To be eligible for inclusion in additional Tier 1, financial included in Tier 2 capital; (3) instruments issued by
instruments must, among other criteria, be: (1) issued subsidiaries that are consolidated with the bank and
and paid in; (2) subordinated to depositors and general held by third parties that meet the criteria for inclusion
creditors of the bank; (3) neither secured nor covered by in Tier 2 capital; (4) general provisions or loan‑loss
a guarantee of the issuer or other arrangement that legally reserves held against future unidentified losses, not
or economically enhances the seniority of the claim ascribed to particular assets or known liabilities;9 and
vis‑à‑vis bank creditors; and (4) perpetual, that is, there (5) regulatory adjustments applied in the calculation
is no maturity and there are no incentives to redeem. of Tier 2 capital.
3.29 Tier 2 capital (Basel I definition continued 3.31 The adjustments to regulatory capital in
in Basel II) consists of financial instruments and Basel I and II include deducting the value of goodwill
reserves that are available to absorb losses, but which from Tier 1 capital, and deduction from total capital
might not be permanent, have uncertain values, might (50 percent from Tier 1 and 50 percent from Tier 2
entail costs if sold, or which otherwise lack the full in Basel II) of the value of investments in unconsoli-
loss-absorption capacity of Tier 1 capital items. These dated banking and financial subsidiaries to prevent
include (1) undisclosed reserves, that is, that part of the multiple use of the same capital resources within
accumulated retained earnings that banks in some the same banking group.10 National authorities have
countries may be permitted to maintain as an undis- the discretion to add to these supervisory deductions
closed reserve; (2) asset revaluation reserves with investment in the capital of other banks and finan-
regard to fixed assets, and with regard to long‑term cial institutions, and other intangible assets. Basel III
holdings of equities valued in the balance sheet at introduced a wider set of deductions to buttress the
historic cost but for which there are “latent” revalu- quality of the capital in times of stress. These deduc-
ation gains; (3) general provisions/general loan loss tions include: (1) goodwill; (2) deferred tax assets;
reserves (up to 1.25 percent of risk‑weighted assets);7 (3) defined benefit pension plan deficits; (4) excess
(4) hybrid instruments that combine the character- minority interest in subsidiaries; (5) profit revalua-
istics of debt and equity and are available to meet tion of own debt; and (6) threshold deductions (other
losses;8 and (5) unsecured subordinated debt with deferred taxes arising from timing differences, mort-
gage servicing rights, and investments in unconsoli-
dated subsidiaries) taken as the excess over 10 percent
7
Provisions held against specific assets are excluded from this of CET1 individually and the excess of 15 percent of
definition of capital.
8
Eligible capital instruments should meet the following
CET1 when considered in aggregate.
requirements: (1) they are unsecured, subordinated, and fully
paid‑up; (2) they are not redeemable at the initiative of the holder
or without the prior consent of the supervisory authority; (3) 9
Up to 1.25 percent of risk‑weighted assets calculated under the
they are available to participate in losses without the bank being standardized approach, and up to 0.6 percent of risk‑weighted
obliged to cease trading (unlike conventional subordinated debt); assets calculated under the IRB approach. At national discretion,
(4) although the capital instrument may carry an obligation to pay lower limits may apply.
interest that cannot permanently be reduced or waived (unlike 10
The assets representing the investment in subsidiary companies
dividends on ordinary shareholders’ equity), it should allow service whose capital had been deducted from that of the parent would
obligations to be deferred (as with cumulative preference shares) not be included in risk-weighted assets for the calculation of capital
where the profitability of the bank would not support payment. adequacy, or total assets when calculating the leverage ratio.

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22 Financial Soundness Indicators Compilation Guide

Risk-Weighted Assets bank would require $8 in capital for each $100 in 100
Credit Risk percent risk-weighted commercial loans ($100 * 1.00 *
0.08), $2 in capital for each $100 in 20 percent risk-
3.32 Basel I introduced the concept of adjusting
weighted debt of another bank ($100 * 0.20 * 0.08),
assets through the application of a weighting fac-
and no capital for $100 in 0 risk-weighted government
tor to approximate risk. Banks are required to hold
bonds ($100*0.0*0.08). Total capital requirements can
the specified minimum capital relative to their risk-
be calculated as follows:
weighted (or risk-adjusted) assets, rather than their
total assets. Basel I initially considered only credit
risk, with the 1996 Amendment incorporating mar- Total Risk-Weighted Assets * 0.08 = Minimum Capital
ket risk by expressing the measure of market risk as Requirement
a risk-weighted asset equivalent. Basel II introduced
3.33 There are four Basel I groupings of assets
an expression of the measure of operational risk as
with corresponding credit-risk weights (Table 3.2).
a risk-weighted asset equivalent. Applying the Basel
Basel II and Basel III have introduced more granular
minimum 8 percent capital adequacy standard, a
versions of the original Basel I approach to credit-risk

Table 3.2 Basel I Risk Weights for On-balance-Sheet Assets

Risk Weight (Percent) Asset Category

Cash, including, at national discretion, gold bullion held in own vaults or on an allocated basis
to the extent backed by bullion liabilities
Claims on central governments and central banks denominated in national currency and
0 funded in that currency
Other claims on OECD central governments and central banks
Claims collateralized by cash of OECD central‑government securities or guaranteed by OECD
central governments
0, 10, 20, or 50 (At Claims on domestic public sector entities, excluding central governments, and loans guaranteed
National Discretion) by such entities
Claims on multilateral development banks and claims guaranteed by or collateralized by
securities issued by such banks
Claims on banks incorporated in the OECD and loans guaranteed by OECD-incorporated
banks
20 Claims on banks incorporated in countries outside the OECD with a residual maturity of
up to one year and loans with a residual maturity of up to one year, guaranteed by banks
incorporated in countries outside the OECD; claims on non domestic OECD public sector
entities, excluding central governments, and loans guaranteed by such entities
Cash items in process of collection
Loans fully secured by mortgage on residential property that is or will be occupied by the
50
borrower or that is rented
Claims on the private sector
Claims on banks incorporated outside the OECD with a residual maturity of over one year
Claims on central governments outside the OECD (unless denominated in national currency—
and funded in that currency—see above)
Claims on commercial companies owned by the public sector
100
Premises, plant and equipment, and other fixed assets
Real estate and other investments (including nonconsolidated investment participations in
other companies)
Capital instruments issued by other banks (unless deducted from capital)
All other assets
Source: BCBS (1988).
Note: OECD = Organisation for Economic Co-operation and Development.

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 Basel Capital and Liquidity Standards for Deposit Takers 23

weighting, breaking the original four groupings of key risk inputs of probability of default (PD), loss given
assets into an increasing number of categories in efforts default (LGD), exposure at default (ED), and effective
to make the standardized approaches more nuanced. maturity (M). In the foundation IRB approach, the bank
An illustration of the increasing granularity is provided provides only the estimates of PD, with the supervisory
in Annex 3.2. Basel II also introduced a treatment of authority prescribing the other risk inputs.
risk-mitigants, whereby risk weights can be adjusted 3.36 Compilers should ensure that the metadata
to reflect the value of collateral and guarantees. Com- indicates whether the national supervisory stan-
pilers requiring additional detail on the standardized dards make the advanced approaches are available to
approaches to risk weights and the treatment of risk- banks. Compilers should not normally require details
mitigants should refer to national supervisory stan- of the internal ratings–based approach to credit risk,
dards and the relevant version of the Capital Accord. but if required, should refer to national supervisory
3.34 All versions of Basel employ conversion fac- standards and the BCBS publications International
tors to determine a credit equivalent amount for off- Convergence of Capital Measurement and Capital
balance-sheet items (Table 3.3). This credit equivalent Standards: A Revised Framework (Basel II, 2004), and
amount is then subject to risk weighting in accor- Basel III: Finalizing Post-Crisis Reforms (2017).
dance with the factor applicable to the counterparty.
3.35 In addition to a more granular standardized Market Risk
approach, Basel II introduced internal ratings–based 3.37 Market risk is the risk of losses in on- and
approaches (IRB) for credit risk, which use models off-balance-sheet positions arising from movements
to determine risk weightings. Subject to supervisory in market prices. The 1996 Amendment to the Capital
approval, banks may use data from their own internal Accord to Incorporate Market Risks introduced capi-
ratings–based models as inputs into the function deter- tal charges for interest rate–related instruments and
mining the capital requirement for credit risk exposures. equities in the trading book (instruments not held
In the advanced IRB approach, the bank provides the primarily for the collection of cash flows), and to total

Table 3.3 Credit Conversion Factors for Off-Balance-Sheet Items

Credit conversion
Instruments factors (in percent)

Direct credit substitutes, eg general guarantees of indebtedness (including standby letters 100
of credit serving as financial guarantees for loans and securities) and acceptances (including
endorsements with the character of acceptances).
Sale and repurchase agreements and asset sales with recourse where the credit risk remains with 100
the bank.
The lending of banks’ securities or the posting of securities as collateral by banks, including 100
instances where these arise out of repo-style transactions.
Forward asset purchases, forward deposits and partly paid shares and securities, which represent 100
commitments with certain drawdown.
Off-balance sheet items that are credit substitutes not explicitly included in any other category. 100
Note issuance facilities and revolving underwriting facilities regardless of the maturity of the 50
underlying facility.
Transaction-related contingent items such as performance bonds, bid bonds, warranties and 50
standby letters of credit related to particular transactions.
Commitments, regardless of the maturity of the underlying facility, unless they qualify for a lower CCF. 40
The issuing and confirming banks of short-term self-liquidating trade letters of credit arising 20
from the movement of goods (e.g. documentary credits collateralized by the underlying
shipment).
Commitments that are unconditionally cancellable at any time by the bank without prior notice, or that 10
effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness.

Source: Basel III

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24 Financial Soundness Indicators Compilation Guide

(trading book plus banking book) currency and com- 3.41 The new capital standards for market risk
modities positions. Banks can measure their market introduced in 2016 revised the required methodology
risk exposure and calculate the required capital using for internal models, and also introduced a much more
the standardized approach or, subject to supervisory detailed standardized approach. Reflecting experi-
approval, internal models. The market risk require- ence in the global financial crisis, the approach shifted
ments remained unchanged in Basel II. A revised from VaR to expected shortfall (ES) to better capture
approach to market risk, including a new standard- tail risk. In addition, both the internal model and
ized approach and revisions to the requirements for standardized approach introduced varying liquidity
internal models was introduced in 2016.11 horizons to incorporate the risk of market illiquid-
3.38 Under Basel I and II, in the standardized ity, and, following on from Basel II.5, made techni-
framework, the capital charge is calculated using fixed cal revisions to more clearly identify the boundary
risk factors. The capital charge for foreign currency between the trading book and banking book.
exposure, for example, is calculated as 8 percent of the 3.42 In January 2019, the BCBS published a revised
overall net currency positions.12 For interest rate and standard for minimum capital requirements for mar-
equity risk (including derivatives), a specific risk (issuer ket risk. The main changes were the introduction of
risk) charge is added to the general market risk charge. a new standardized approach and simplified stan-
3.39 Under Basel I and II, banks with well‑estab- dardized approach to enhance market risk sensitivity,
lished risk management practices are allowed, subject clearer delineation of the boundary between the trad-
to supervisory approvals, to calculate market risk reg- ing book and the banking book, and more detailed
ulatory capital requirement using their own value at and stringent requirements for banks’ internal market
risk (VaR) estimates.13 Supervisory approval is subject risk models and the processes for supervisory review.
to certain conditions, including daily VaR back‑tests, 3.43 Compilers should be aware of whether capital
that is, to test the validity of the VaR measure by com- charges for market risk have been incorporated into
paring VaR figures to actual or hypothetical outcomes. national supervisory standards and should disclose
3.40 Reflecting experience in the global financial in the metadata whether the approach is based on
crisis with models significantly underestimating actual the Basel I and II approach, the Basel II.5 revisions,
volatility and the probabilities of extreme tail events, or Basel III. Any national variations from the Basel
the 2009 revisions to Basel II, often called Basel II.5, regime should be noted. Compilers will generally not
introduced a number of changes to the calculation of need the details of the standardized or internal model
capital requirements for market risk. These included calculations of market risk capital requirements but if
(1) the calculation of VaR under stressed market con- required should refer to the relevant Basel publications.
ditions; (2) a new incremental risk charge to capture Operational Risk
default and credit mitigation risk; (3) for securitized
3.44 Operational risk is defined as the risk of loss
products, the application of the same capital charge
resulting from inadequate internal procedures or from
applied for exposures in the banking book; and (4) an
external events. This definition includes legal risk
incremental charge for credit risk in the trading book
but excludes strategic and reputational risks. Capital
to minimize capital arbitrage by eliminating the dif-
charges for operational risk were introduced in Basel II.
ference in capital requirements for identical instru-
Initially banks were to choose from three methods
ments held in the trading book and banking book.
to calculate the capital required for operational risk:
(1) the basic indicator approach; (2) the standard-
11
BCBS, Minimum Capital Requirements for Market Risk (2016). ized approach, and (3) the advanced measurement
12
The overall net open position is measured by aggregating (1) approaches. The advanced measurement approaches
the sum of the net short positions or the sum of the net long
positions, whichever is the greater; plus (2) the net position (short were later withdrawn, reflecting that the state of the art
or long) in gold, regardless of sign. of operational risk management was not as advanced
13
VaR measures the maximum likely loss in a given period of as credit and market risk management. Basel III intro-
time in the event of extreme market moves. It is calculated at a
confidence level of 99 percent over a 10‑day holding period, using duced in 2017 a new standardized approach, using
at least 250 days of data. business line revenues and assumed or observed

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 Basel Capital and Liquidity Standards for Deposit Takers 25

operational loss experience as inputs, replacing the 3.48 Compilers will rely on supervisory sources for
two other options for calculating operational risk. leverage data but should note in the metadata whether
3.45 Compliers should disclose in the metadata the national definition is aligned with either the origi-
whether capital charges for operational risk have been nal or revised Basel definition.
adopted in national supervisory frameworks, and, if so, Liquidity Standards
which calculation methods are available to banks. Fur-
3.49 Basel III introduced two internationally
ther detail on operational risk capital charges should not
harmonized global liquidity standards: the LCR
normally be needed by compilers but, if required, can
and NSFR. These two ratios are calculated using
be obtained from national supervisory standards and
prescribed stress-scenarios and agreed interna-
BCBS Basel III: Finalising Post-Crisis Reforms (2017).
tional definitions of HQLA. National implemen-
tation may vary, and compilers should rely on
Leverage Ratio national supervisory standards. Some jurisdictions
may apply the LCR and NSFR requirements only
3.46 Basel III introduced a non-risk-based lever-
to a sub-set of banks, for example, only large inter-
age ratio to serve as a supplementary measure to
nationally active banks. As described in Chapter 7,
the risk‑based capital requirements. Banks were ini-
the LCR and NSFR FSIs should be compiled based
tially required only to disclose their leverage ratio as
on aggregation of those banks to which the stan-
defined in the original 2010 Basel III text. The capital
dards apply.
measure (numerator) is Tier 1 capital (Basel III defini-
tion), and the exposure measure (denominator) com- Liquidity coverage ratio
prises all balance sheet assets, derivatives exposures,
3.50 The LCR is intended to promote resilience to
securities financing transaction exposures, and off-
potential liquidity disruptions over a 30 day horizon.
balance-sheet items. Exposure as defined in Basel III
The LCR standard is defined by dividing the stock of
provides a more comprehensive measure of risk than
HQLA by net cash outflows over a 30‑day time period
on- and off-balance-sheet items by requiring the use
under stressed conditions. Unlike other liquidity FSIs
of the accounting measure of exposure plus regula-
(except the net stable funding ratio discussed fur-
tory requirements with respect to derivatives, repur-
ther), the LCR is not a ratio of balance sheet items,
chase agreements and securities finance, committed
but rather the result of a supervisor-prescribed stress
credit facilities, direct credit substitutes, and other
scenario. Compilers will rely on supervisory data
specified items. The exposure measure was revised in
sources.
December 2017.
3.51 Phased implementation ends in 2019, mean-
3.47 By 2018, banks were required to hold Tier 1
ing that HQLA must equal or exceed a stressed
capital equal to at least 3 percent of the exposure
one‑month cash outflow using run-off rates pre-
measure as originally defined and have until 2022
scribed by the supervisory authority.
to meet the 3 percent requirement using the revised
exposure definition. In addition, the December 3.52 HQLA are those assets that can be eas-
2017 revisions introduced a requirement for a lever- ily and immediately converted into cash at little
age buffer for global systemically important banks or no loss of value. Basel III sets out fundamental
(G-SIB). The leverage buffer add-on is equal to half and market‑related characteristics and operational
of the G-SIB buffer the bank is required to hold. requirements that HQLA should possess or satisfy.
For example, a G-SIB with a capital buffer of 1 per- These assets should be unencumbered, liquid in
cent would be required to meet a leverage limit of markets during a time of stress and, ideally, eligible
3.5 percent—the broadly applicable 3 percent lever- as collateral for the central bank standing liquidity
age limit, plus a leverage buffer equivalent to half facilities.
of the applicable G-SIB buffer. Implementation will 3.53 Implementing the LCR will be challenging in
be phased in through 2022. There is the option, at many countries because of a lack of assets that would
national discretion, of early adoption of the revised meet the Basel definition of HQLA.14 Compilers
exposure measure. should provide in the metadata definitions of HQLA if

©International Monetary Fund. Not for Redistribution

26 Financial Soundness Indicators Compilation Guide

these differ from the Basel standard. Full details of the over a one-year horizon. Calibration of the presumed
Basel definition are available in the 2010 Basel III text. degree of stability considers the funding tenor, the
funding type, and counterparty. Required stable
Net stable funding ratio funding is institution-specific, reflecting the liquid-
3.54 The NSFR is defined as the ratio of the avail- ity characteristics and residual maturities of its assets
able amount of stable funding relative to the amount and its off-balance-sheet exposures. Compilers will
of required stable funding over a one-year time hori- rely on supervisory data and will not generally need
zon. Like the LCR, but in contrast to other liquidity to be familiar with the highly detailed specification of
FSIs, the NSFR is not a ratio of balance sheet items, available stable funding and required stable funding
but the outcome of a supervisor-prescribed stress (RSF). Additional detail, if required, can be obtained
scenario applied to individual banks. It is intended from national supervisory standards and BCBS Basel
to limit overreliance on short-term wholesale fund- III: The Net Stable Funding Ratio (2014).
ing, encourage assessment of funding risks across all
on- and off- balance sheet items, and promote funding IV. Aggregation of Capital Components
stability. The NSFR should be greater than 100 percent under Different Basel Accords
and complements the short-term horizon of the LCR. 3.56 In some countries, there may be different
3.55 Available stable funding (ASF) is defined as prudential standards for different types or classes of
the portion of a banks’ capital and liabilities that are bank. If differing capital definitions are in force, for
expected to remain with the bank in a stress scenario example, Basel III for larger banks and an earlier defi-
nition for savings or mutual banks, this will create a
problem for aggregating internal data based on differ-
14
This will be a significant problem in countries that do not ent regulatory frameworks. Table 3.4 summarizes the
have liquid domestic securities markets. Also, it is a problem for
Islamic financial institutions that are constrained from holding recommended approach for aggregating on different
interest-bearing instruments. regulatory frameworks.

Table 3.4 Recommended Aggregation of Capital Components under Basel III and Basel II (or Basel I)
for Deriving Sectoral Data

Sectoral data calculated by

aggregation of capital data under
Basel I Basel II Basel III different Basel standards

Tier I Tier I CET1* Sectoral CET1 = Common Equity Under

Basel I and II + Basel III CET1*
Tier 1 (CET1*+ AT1*) Sectoral Tier 1 = Basel I Tier 1 + Basel II
Tier 1 + Basel III Tier 1
Tier 2 Tier 2 Tier 2* Sectoral Tier 2 = Basel I Tier 2 + Basel II
Tier 2 + Basel III Tier 2*
Tier 3 Tier 3 Tier 3 is eliminated Sectoral Tier 3 (if applicable) = Basel I
Tier 3 + Basel II Tier 3
Supervisory Supervisory adjustments Supervisory adjustments Sectoral supervisory adjustments =
adjustments (except (except for goodwill) are deducted from Basel I supervisory adjustments +
for goodwill) are are deducted 50 each component of Basel II supervisory adjustments (as
deducted from total percent Tier 1 and 50 regulatory capital applicable)
regulatory capital percent Tier 2
Basel I total regulatory Basel II total regulatory Basel III total regulatory Sectoral Total Regulatory Capital =
capital = Tier 1 + Tier 2 + capital=Tier 1 + Tier 2 + capital = Tier 1 (CET1* Sectoral Tier 1 + Sectoral Tier 2 +
Tier 3 (if applicable) – Tier 3 (if applicable) – + AT1*) + Tier 2* Sectoral Tier 3 (if applicable) – Sectoral
supervisory supervisory adjustments supervisory adjustments (as applicable)
adjustments
Source: IMF staff.
Note: AT1 = Additional Tier 1; CET1 = Common Equity Tier 1.
*Net of supervisory adjustments.

©International Monetary Fund. Not for Redistribution

ANNEX

3.1 The Basel Regulatory Frameworks

Basel I Basel II Basel III

Capital adequacy framework Capital adequacy framework Capital adequacy framework

Definition of capital Definition of capital Definition of capital
• Tier 1 capital (equity and disclosed reserves) • No changes from Basel I except (i) significant • Common Equity Tier 1 (equity and
• Tier 2 capital (undisclosed and revaluation investments in capital instruments of insurance disclosed reserves)
reserves, general provisions up to companies and minority investments in the capital • Additional Tier 1 (subordinated
1.25 percent of risk-weighted assets, instruments of banking, securities and other instruments with no maturity)
subordinated debt) financial entities are to be deducted 50 percent • Tier 2 (long-term subordinated debt)
• Tier 3 capital (medium-term debt with lock-in from Tier 1 and 50 percent from Tier 2 capital; • Wider set of supervisory deductions
provisions) and (ii) banks using the advanced approaches that apply to CET1 and AT1
• Supervisory deductions (goodwill and other must deduct any shortfall in provisions relative • Capital conservation buffer
intangibles) applied to Tier 1 capital to expected loss from capital (50 percent Tier 1, • Countercyclical capital buffer
• Investment in unconsolidated subsidiaries 50 percent Tier 2), and may include any surplus in • Systemic risk charge for G‑SIFIs
deducted from total capital Tier 2, to a maximum of 0.6 percent of RWA. • Tier 3 capital is eliminated
Credit risk Credit risk Credit risk
• Simple fixed risk-weights • More sensitive measures of risk • More granular Standardized
• Four risk categories • Standardized approach Approach, and introduction of an
• From 0 to 100 percent • Internal ratings-based approach alternative to external ratings.
• Foundation IRB approach • Restrict the use of Advanced IRB
• Advanced IRB approach approach for exposures to banks,
financial institutions and certain
large corporates.
• Equity exposures are subject to the
standardized approach only.
Market risk Market risk Market risk
• Explicit cushion for price risks, in particular • No changes from Basel I • More integrated management of
from trading activities market risk
• New standardized and simplified
standardized approaches
• Clearer delineation of the boundary
between the trading book and
banking book.
Operational risk Operational risk
• Basic indicator approach • New Standardized approach replaces
• Standardized approach all other options
• Advanced measurement approach
Leverage ratio
• Simple, transparent, and non‑risk-
based leverage ratio
New liquidity framework
• Short‑term ratio (LCR)
• Longer‑term ratio (NSFR)
Supervisory review process Supervisory review process
• Cover other risks (concentration, reputational, etc.) • Enhanced oversight of credit and
• Supervision should go beyond capital market risks
requirements compliance
Disclosure requirements Disclosure requirements
• To encourage market discipline • Additional disclosures for credit,
market, and liquidity risk supplement
Basel II disclosures

Source: IMF staff.

Note: AT1 = Additional Tier 1; CET1 = Common Equity Tier 1; G-SIFI = global systemically important financial institution; IRB = internal
rating based.

©International Monetary Fund. Not for Redistribution

ANNEX

3.2
Illustration of Increasing
Granularity in Standardized
Approaches to Credit Risk

Basel I Basel II Standardized Basel III Standardized

Risk
Category weight Category Risk weight Category Risk weight
Residential Loans fully 50 percent Loans fully 35 percent LTV ≤ 50 20 percent*
mortgages secured by secured by 30 percent#
mortgage mortgages 50 < LTV ≤ 60 25 percent*
on on 35 percent#
residential residential 60 < LTV ≤ 80 30 percent*
property property
45 percent#
80 < LTV ≤ 90 40 percent*
60 percent#
90 < LTV ≤ 100 50 percent*
75 percent#
LTV >100 70 percent*
105 percent#
Commercial All loans 100 AAA to AA– 20 percent AAA to AA– 20 percent
loans percent A+ to A– 50 percent A+ to A– 50 percent
BBB+ to BB– 100 percent BBB+ to BBB– 75 percent
BB+ to BB– 100 percent
Below BB– 150 percent Below BB– 150 percent
Unrated 100 percent Unrated 100 percent
SME 85 percent
Project finance 80 – 130 percent
Object finance 100 percent
Commodities finance 100 percent
Sources: Basel I, Basel II, Basel III: Finalizing Post Crisis Reforms.
* Risk weights for mortgages where repayment is not dependent on cash flow from renting the property.
#
Risk weights for mortgages where repayment is dependent on cash flow from renting the property.

©International Monetary Fund. Not for Redistribution