How Do You Determine Solvency Ratio Requirements Under the Basel III Accord?

Basel III—also referred to as the Third Basel Accord or Basel Standards—is a 2009 international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision, and risk management within the international banking sector. Basel III required that banks maintain proper leverage ratios and keep certain levels of reserve capital on hand. This framework was introduced in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08.

A leverage ratio is a financial measurement that assesses how much capital comes in the form of debt and assesses the ability of a company to meet its financial obligations. Reserve capital refers to the capital buffers that banks have to establish to meet regulatory requirements. The capital adequacy ratio measures a bank’s capital in relation to its risk-weighted assets.

What Is the Solvency Ratio?

The solvency ratio is a key metric used to measure an enterprise’s ability to meet its debt obligations and is used often by prospective business lenders. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-and long-term liabilities.

The solvency ratio is used to determine the minimum amount of common equity banks must maintain on their balance sheets. The solvency ratio—also known as the risk-based capital ratio—is calculated by taking the regulatory capital divided by the risk-weighted assets.

Risk-weighted assets are a financial institution’s assets or off-balance-sheet exposures weighted according to the risk of the asset. Risk-weighted assets are the denominator in the calculation to determine the solvency ratio under the provisions of the Basel III final rule.

Under Basel III, the minimum capital adequacy ratio that banks must maintain is 8%.

The Formula for the Solvency Ratio

The formula for calculating the solvency ratio is as follows:

Basel III Increased Requirements for Common Equity

Basel III increased the amount of common equity that banks must hold. For example, under Basel III, banks are required to hold 4.5% of common equity of risk-weighted assets, with an additional buffer of 1.5%. The common equity percentage increased from Basel II, which only required 2%. Basel III builds on the Basel I and Basel II documents, with an emphasis on improving the banking sector’s ability to deal with financial stress, improve risk management, and promote transparency. More generally, Basel III was intended to prevent future economic meltdowns.

In the wake of the 2008 credit crisis, the passage of Basel III sought to improve risk management for financial institutions. Basel III changed how risk-weighted assets are calculated. Under Basel III, U.S. government debt and securities are given a risk weight of 0%, while residential mortgages not guaranteed by the U.S. government are weighted anywhere from 35 to 100%, depending on a risk assessment sliding scale. Previously under Basel II, residential mortgages had a flat risk weighting of 100% or 50%.

Basel III increased the risk weighting for particular bank trading activities, especially swaps trading. Critics of Basel III claim that it places undue regulations on banks for these trading activities and has allegedly reduced their profitability. Basel III encourages the trading of swaps on centralized exchanges to reduce counterparty default risk, often cited as a major cause of the 2008 financial crisis. In response, many banks have severely curtailed their trading activities or sold off their trading desks to non-bank financial institutions.

Basel III was introduced shortly after the credit crisis of 2008 by the Basel Committee on Banking Supervision, a consortium of central banks from 28 countries, Although the voluntary implementation deadline for the new rules was originally 2015, the date has been repeatedly pushed back and currently stands at January 1, 2022.