The growth-at-risk perspective on the system-wide impact of Basel III finalisation in the euro area

Katarzyna Budnik, Ivan Dimitrov,

Carla Giglio, Johannes Groß, Max Lampe,

Andrei Sarychev, Matthieu Tarbé,

Gianluca Vagliano, Matjaž Volk

Occasional Paper Series

The growth-at-risk perspective on the system-wide impact of Basel III finalisation in the euro area

No 258 / July 2021

Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.

Contents

Abstract		3
Executive summary	4
1	Introduction	6
2	Basel III finalisation	9
3	Methodology	12
	3.1	The model	12
	3.2	Modelling the implementation of the Basel III finalisation reforms	14
	3.3	Growth-at-risk perspective	14
	Box 1 A literature overview comparing the existing approaches to
		growth-at-risk assessment	16
4	Costs of the Basel III finalisation in normal economic conditions	18
	Box 2 Revision in risk weighted amounts (RWA) versus the equivalent
		revision of regulatory capital ratios	24
5	The resilience-building benefits of Basel III finalisation	27
	5.1	Growth-at-risk	27
	5.2	Looking at crisis events	29
	5.3	Net benefit estimate	30
6	Selected results	33
	6.1	How do banks close the capital gap in the transition phase?	33
	6.2	Bank profitability matters for the economic costs of the reform	36
	6.3	Evolution of bank solvency and leverage	39
	6.4	Higher loss-absorbing capacity	42
	6.5	A sustained reduction in funding costs	43
	6.6	Selected elements of the Basel III finalisation	47
7	Conclusions and policy implications	51
References		53
Appendix: Model description	55

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A.1	Bank-level behavioural equations	55
A.2	Bank sensitivities to external environment	57
A.3	The real economy and banking sector feedback loop	58
A.4	Assumptions for stochastic simulations	58
A.5	Implementation of the Basel III finalisation in the model	59

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Abstract

This paper assesses the macroeconomic implications of the Basel III finalisation for the euro area, employing a large-scalesemi-structural model encompassing over 90 banks and 19-euro area economies. The new regulatory framework will influence banks' reactions to economic conditions and, as a result, affect the ability of the banking system to amplify or dampen economic shocks. The assessment covers the entire distribution of conditional economic predictions to measure the cost and benefit of the reforms. Looking at the means of conditional forecasts of output growth provides an indication of the costs of the reform, namely a transitory reduction in euro area gross domestic product (GDP) and in lending to the non-financial private sector. Looking at the lower percentile of output growth forecasts, i.e. growth at risk, captures the long-term benefits of the Basel III finalisation package in terms of improved resilience and the ability of the banking system to supply lending to the real economy under adverse conditions. These permanent growth-at-risk benefits ultimately outweigh the short-term costs of the reform.

JEL Codes: E37, E58, G21, G28

Keywords: Basel III finalisation, impact assessment, regulatory policy, banking sector, real-financial feedback mechanism

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Executive summary

The finalisation of the Basel III framework will limit the potential for regulatory arbitrage arising from the use of internal models and reduce variations in risk estimates. The reform package was published at the end of 2017 (Basel Committee on Banking Supervision, 2017) and was expected, at that time, to result in an aggregate shortfall of about EUR 83 billion in terms of Common Equity Tier 1 (CET1) at European Union level (EBA, 2019). The introduction of the Basel III finalisation was postponed by one year in response to the impact of COVID-19developments and is currently expected to come into effect by 1 January 2023, with the accompanying transitional arrangements for the output floor continuing until 1 January 2029.

This paper presents an assessment of the impact of the Basel III finalisation on the euro area economy from a growth-at-risk perspective. The impact assessment employs a large-scale semi-structuralmodel reflecting the dynamics of 91 significant euro area banks and 19-euroarea economies. The model captures the impact of the reforms on the banks' balance sheets, on their loan supply and on the real economy. The innovative part of the methodology is its focus on the full distribution of possible outcomes, reflecting uncertainty about future economic developments. The growth-at-risk(GaR) perspective means looking at the "tails" of the distributions of macro-financialvariables to assess the resilience of the system.

The implementation costs of the Basel III finalisation amount to the deterioration in macroeconomic variables under normal economic conditions and compared to a scenario in which the Basel III finalisation was not implemented. Under normal macroeconomic conditions, the initial impact of the Basel III finalisation would be an increase in risk exposure amounts (REA) of around 25%. This increase in REA would translate into a reduction in the euro area wide CET1 ratio of 2.5 percentage points. Over a 10-yearhorizon banks would manage to fully close the gap in the CET1 ratio. The effect on the real economy would be contained. In the short term - namely in the first four years following the reform - it is anticipated that annual GDP growth would be around 0.2 percentage points lower under the new regime. However, the growth dynamic reverses thereafter, and GDP expands cumulatively by about 0.5 percentage points over the next five years. The long-termeffect on the expected growth level of the euro area GDP would be zero.

The benefits would arise from the improvement in macroeconomic variables under adverse conditions, as measured by the lower percentiles of the output growth distribution akin to the GaR metrics. In the long term, adverse GDP growth outcomes, falling into the 10th percentile of the GDP growth distribution, were around 0.1 percentage points higher, reflecting a combination of both a lower likelihood of very deep recessions occurring and milder recession outcomes. Recessions would become shorter, shallower and less costly, with a median recession resulting in GDP losses being around 0.2 percentage points lower.

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