May 01, 2019

IMF published a working paper that discusses issues in calibrating the Basel III countercyclical capital buffer (CCyB) based on a sample of EU countries. The paper aims to point to issues in CCyB calibration that may emerge when countries feature some unusual characteristics like short financial cycles and low financial deepening. The paper also analyzes issues in calibrating an appropriate size of the CCyB and, using a loss function approach, points to a trade-off between stability of the buffer size and cost efficiency considerations.

The paper argues that the the credit-to-GDP gap, which is the main indicator for buffer decisions under the Basel III framework, does not always work best in terms of covering bank loan losses that go beyond what could be expected from economic downturns. Instead, in the case of countries with short financial cycles and/or low financial deepening such as transition and developing economies, the Basel gap is shown to work best when computed with a low, smoothing factor and adjusted for the degree of financial deepening. Using data for the EU-27 countries, the paper concludes that the BCBS credit gap does not work well, because of the heterogeneity of the sample comprising roughly as many transition economies as mature ones. However, this conclusion might be different if using a broader set of countries or a different time horizon. 

Another contribution of the paper is to reexamine the BCBS buffer guide using different thresholds for minimum and maximum gaps/CCyB sizes, as policymakers may have different preferences for avoiding insufficient buffers versus shunning high costs of excessive buffers. If losses are large and cannot be fully covered under the maximum gap threshold, the BCBS buffer guide is adequate only for policymakers who want to safeguard against insufficient buffers in the run-up phase using a low minimum threshold. By contrast, those with more balanced preferences would likely choose higher thresholds considering the cost of excessive buffers that needs to be viewed in relation to the losses to be covered. The choice of a particular buffer guide also depends on the interval during which deviations from the required buffer size are analyzed, although it is not clear that longer intervals would necessarily suggest different optimal threshold combinations than shorter intervals. 

In calibrating the CCyB, policymakers not only have the option to modify the credit gap but to use other indicators, either in isolation or in addition to the credit gap. The paper points to the merit of house price growth as a triggering variable. However, there may be other indicators, or a combination of indicators, that predict crises better in individual country cases than the credit gap in isolation does. As the paper illustrates, this choice should also take into account policymakers’ objectives and risk tolerance. After all, the BCBS buffer guide represents merely an input to the decision-making process of national authorities rather than an automatism and it may be complemented by other methods such as stress testing.

 

Related Link: Working Paper (PDF)

 

Keywords: Global, Europe, Banking, Basel III, CCyB, Macro-Prudential Policy, Risk-Weighted Assets, Procyclicality, IMF

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