Conceptual Issues in Calibrating the Basel III Countercyclical Capital Buffer

IMF Working Papers, May 1, 2019

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The credit-to-GDP gap, the main indicator in the Basel III framework for buffer decisions, does not always best cover bank loan losses that exceed what would be expected from economic downturns.
For countries with short financial cycles and/or low financial deepening (for example, transition and developing economies), the Basel gap performs best when:
- computed with a low, smoothing factor; and
- adjusted for the degree of financial deepening.
Using a loss function approach to calibrate CCB size highlights a tradeoff between:
- stability of the buffer size, and
- cost efficiency considerations.

The paper evaluates the Basel gap (credit-to-GDP gap) across a sample of EU countries and compares its ability to signal and cover loan losses beyond cyclical downturns.
Adjustment for financial deepening is important in economies with lower levels of financial development or shorter financial cycles.
A lower smoothing factor in the Basel gap computation improves performance in these economies.

Calibrating an appropriate size for the countercyclical capital buffer requires balancing competing objectives:
- Larger, more stable buffers can better absorb loan losses during stress events.
- Smaller buffers may be more cost-efficient for the banking sector and the wider economy.
The loss function framework used in the paper formalizes this tradeoff to guide calibration choices.

Subjects: Credit, Credit gaps, Financial crises, Financial cycles, Financial sector policy and analysis, Housing prices, Money, Prices
Keywords: Basel gap specification, Basel III, BCBS buffer guide, BCBS calibration, BCBS gap definition, Central and Eastern Europe, Credit, Credit gaps, credit-to-GDP gap, credit-to-GDP ratio, Eastern Europe, Financial cycles, Global, Housing prices, loan loss, Macroprudential Policy, Procyclicality, WP

Conceptual Issues in Calibrating the Basel III Countercyclical Capital Buffer, Torsten Wezel, May 1, 2019.