Three Pillars of Basel III

The Basel III Framework is an internationally accepted set of banking regulations developed by the Basel Committee on Banking Supervision (BCBS) to strengthen the regulation, supervision, and risk management of the banking sector. Introduced in 2010, Basel III was designed in response to the 2008 global financial crisis, which exposed severe weaknesses in banks’ capital adequacy, liquidity management, and risk control mechanisms.
Like its predecessor (Basel II), the Basel III framework is built on three fundamental pillars — known as the Three Pillars of Basel III — which together ensure financial stability, transparency, and resilience in the banking system.

Overview of Basel III

• Objective: To enhance the banking sector’s ability to absorb financial shocks, improve risk management, and strengthen overall transparency.
• Implementation: Began in 2013, with full implementation expected by 2023–2025 (phased adoption across countries).
• Core Focus: Capital adequacy, liquidity standards, and leverage controls.

The Three Pillars of Basel III

Pillar 1: Minimum Capital Requirements

Objective: To ensure that banks hold sufficient capital to cover their risks and absorb unexpected losses, thereby safeguarding depositors and maintaining stability in the financial system.

Key Components of Pillar 1:

1. Capital Adequacy Ratio (CAR):
   • Banks are required to maintain a minimum ratio of regulatory capital to risk-weighted assets (RWA).
   • Under Basel III, the minimum total capital requirement is 8% of RWA.
   • In addition, Basel III introduced:
     • Capital Conservation Buffer (CCB): 2.5% of RWA (to be maintained in good times).
     • Countercyclical Capital Buffer: 0–2.5% (to be built up in economic booms and used in downturns).

   Thus, the total minimum capital requirement becomes:

   8%+2.5%+(0–2.5%)=10.5% or more.8\% + 2.5\% + (0–2.5\%) = 10.5\% \text{ or more.}8%+2.5%+(0–2.5%)=10.5% or more.

2. Quality of Capital (Tier Structure): Basel III strengthened the definition of capital, focusing on high-quality capital that can genuinely absorb losses.
   • Tier 1 Capital (Core Capital):
     • Common Equity Tier 1 (CET1): At least 4.5% of RWA.
     • Additional Tier 1 (AT1): Up to 1.5%.
   • Tier 2 Capital (Supplementary Capital): Up to 2% of RWA.
3. Leverage Ratio:
   • Introduced to limit excessive borrowing.
   • Defined as Tier 1 Capital / Total Exposure, minimum 3%.
4. Risk Coverage:
   • Pillar 1 covers three primary risks:
     • Credit Risk – risk of borrower default.
     • Market Risk – risk of losses due to changes in market prices.
     • Operational Risk – risk of loss from inadequate internal processes or systems.

Outcome: Pillar 1 ensures that banks hold sufficient, high-quality capital to remain solvent even during financial stress.

Pillar 2: Supervisory Review Process (SRP)

Objective: To ensure that banks not only meet minimum capital requirements but also adopt robust internal procedures to assess and manage all material risks beyond those covered in Pillar 1.

Key Components of Pillar 2:

1. Internal Capital Adequacy Assessment Process (ICAAP):
   • Banks must develop their own process for assessing overall capital adequacy relative to their risk profile.
   • Encourages a proactive approach to risk management.
2. Supervisory Review and Evaluation Process (SREP):
   • Supervisors review banks’ internal assessments and ensure capital levels are appropriate.
   • Regulators can require banks to hold additional capital buffers if deemed necessary.
3. Broader Risk Coverage: Pillar 2 includes risks not fully captured under Pillar 1, such as:
   • Interest Rate Risk in the Banking Book (IRRBB)
   • Liquidity Risk
   • Concentration Risk
   • Strategic and Reputational Risk
4. Corrective Measures:
   • Regulators can take action against banks that fail to maintain adequate risk controls or capital levels.

Outcome: Pillar 2 promotes a comprehensive supervisory framework, encouraging both banks and regulators to focus on the quality of risk management rather than just quantitative ratios.

Pillar 3: Market Discipline

Objective: To enhance transparency and market discipline by requiring banks to publicly disclose key information about their financial condition, capital structure, and risk exposures.

Key Components of Pillar 3:

1. Public Disclosure Requirements:
   • Banks must regularly disclose details of:
     • Capital adequacy ratios and composition.
     • Risk exposure and management practices.
     • Leverage, liquidity, and funding profiles.
   • Ensures that investors, analysts, and stakeholders can assess a bank’s financial strength.
2. Enhanced Transparency:
   • Promotes accountability and trust in the financial system.
   • Enables the market to penalise or reward banks based on their risk management and financial soundness.
3. Key Disclosure Areas:
   • Risk-weighted assets and capital adequacy.
   • Credit and market risk exposure.
   • Securitisation activities and off-balance-sheet items.
   • Remuneration policies for top management.

Outcome: Pillar 3 strengthens market discipline by allowing informed participants to monitor banks, thereby complementing the regulatory oversight of Pillars 1 and 2.