Improving Banking Supervisory Mechanisms
In the OIC Member Countries
9
 Improving the quality of bank capital
 Dealing with pro-cyclicality: Capital Buffers
 More capital penalty for complex derivatives and securitizations
 Introduction of a new constraint on the leverage ratio
 Introduction of new measures for liquidity: Liquidity Coverage Ratio (LCR) and Net
Stable Funds Ratio (NSFR)
 Dealing with systemic risk: A new concept, Globally Systemically Important Banks, or
GSIB
 Changing the supervisory mechanisms to adopt these global changes
Quality of Capital
Basel III redefines capital which is used to measure the capital adequacy of banks, as a
response to the insufficiency of the requirements on the quality of capital used to calculate
ratios under Basel II. As it surfaced after the financial crisis in 2008, banks with strong
solvency ratios exhibit limited tangible common equity during the time of stress which led to
the renewed own fund definition to improve quality, consistency and transparency of capital,
which are:
 Common equity (common shares and retained earnings) must be the dominant form
Tier 1 capital.
 Tier 2 capital is simplified and reduced, and includes assets with loss-absorbent
capacity.
 Elimination of Tier 3 capital and imposition of a more stringent criteria for each
instrument.
The own funds requirements as a percentage of risk-weighted assets are also modified by
Basel III. Total capital ratio remains at 8% of the risk-weighted assets. However, Common
Equity Tier 1 ratio is raised from 2% to 4.5%, and with the additional Tier 1 ratio of 1.5%, the
ratio of Tier 1 capital is increased to 6%. The weight of Tier 2 capital is reduced under Basel III
to 2% of total risk-weighted assets.
Timeline: By 2018, the majority of banks' capital should be based on common equity and Tier
1 capital (4.5% and 6% respectively)11.
Pro-cyclicality and Capital Buffers
Another important measure introduced by Basel III is the countercyclical buffer of capital and
leverage ratio, which are significantly different from Basel II. During episodes with low
inflation and low returns, investors seeking high returns incur more risk and increase their
leverage, which drives up asset prices. However, during times of stress, losses incurred by
banks are amplified as a result of deleveraging. This puts a downward pressure on asset prices
which reduces the quality of capital further. Capital regulations imposed by Basel II were pro-
cyclical and exacerbated the risk of asset downturn spirals by allowing banks to increase their
leverage during relatively stable economic conditions. The countercyclical buffer requirement
of Basel III aims to mitigate such risks by requiring an additional capital buffer to
counterbalance pro-cyclical lending. The additional capital buffer will be linked to the size of
the business cycle and will to range between 0 and 2.5% additional Common Equity Tier 1
(CET 1) ratio.
11See time table for Basel III.