The Impact of the Output Floor in the Final Basel III Package

In December 2017, the Basel Committee agreed on a new regulatory framework to address identified shortcomings of the original Basel III agreement, denoted the ‘Final Basel III Standard’. The reform introduces the concept of an output floor, with the motivation to create a backstop for excessively low modelled capital requirements compared to a realistic assessment of risks, and to enhance comparability of capital ratios between banks. How exactly this output floor and the Final Basel III Standard in general are implemented will determine its effect on the Danish banking sector and the Danish economy.

In light of the upcoming implementation of the package and our previous research, Finance Denmark has asked Copenhagen Economics to analyse the impact of the different options on the Danish banking sector and the real economy.

If the reform is implemented according to the European Banking Authority’s (EBA) main scenario, we find that:

• Danish banks could have to raise additional CET1 capital of between DKK 58-90 bn (EUR 7.7-12 bn), depending on the extent to which capital buffers are fully replenished.
• The higher capital need means that banks need to hold a higher share of the more expensive equity, which increases costs for banks. In total, we estimate an annual increase in costs associated with lending of up to DKK 13 bn (EUR 1.7bn).
• Our results suggest that particularly large corporates will be heavily affected by the reform, with borrowing costs increasing by around 0.3-0.4 percentage points on average.
• As a consequence of increased costs of borrowing for business customers investment activity in the Danish economy will be lower. This will ultimately reduce productivity and GDP. We estimate the permanent net social costs of the reform to amount to 0.6%-0.9% of GDP.

We find that an alternative implementation of the output floor, the so-called parallel stacks approach to be more consistent with economic considerations as well as the original spirit behind the Final Basel III Standard. This way of implementing the reform would:

• Largely keep the link between capital requirements and underlying risks for assets, letting the output floor work as a backstop only for excessively low modelled risks.
• Lead to a smaller but still significant impact on capital requirements (around 15% increase in Denmark), with resulting smaller impact on borrowing costs.
• Be closer to the impact on a global level, where capital requirements are expected to increase by much less.
• Bring the impact more in line with the original G20 mandate, which stated that the Basel III framework should be completed “without further significantly increasing overall capi-tal requirements across the banking sector”.

The study is commissioned by the Finance Denmark.