The impact of Basel III regulation in a DSGE model for Norway with credit market imperfections

Abstract

The aim of this thesis is to investigate the medium term economic impact of the new capital regulatory standards (the Basel III reform) for Norway using a standard semi-structural dynamic stochastic general equilibrium (DSGE) model with credit market imperfections. The following questions are answered: (i) what are the major expected effects of higher minimum capital requirement on the Norwegian banking sector and on medium-term economic performance? (ii) How is the inclusion of a proposed countercyclical capital buffer, when made dependent on either the credit-to-GDP or the real credit growth as common reference point, affecting the model economy and in particular GDP and credit growth?

The main findings of this study are the following: (1) each percentage point increase in the capital adequacy ratio translates into a 0.50 per cent loss in the level of steady state output. The long-run effect of a persistent shock to the capital adequacy ratio equation propagates through the banking sector block in the model to the real sector, affecting output by as much as -0.55 percentage points at its peak before shifting output to a new steady-state level between 0.50 and 0.55 percentage below its initial level. (2) The application of a countercyclical capital buffer based on a prudential rule that increases the capital requirement when the credit-to-GDP ratio rises seems capable of moderating credit growth in the model, but it increases the output volatility. More up to date findings in the literature suggest that the use of credit-to-GDP gap as a common reference point could be flawed and at worst increase the inherent pro-cyclicality of bank capital regulation. Reproducing the same methods to investigate this issue for Norway seems to confirm this undesirable property. Findings from the estimated model suggest that the use of a buffer, with credit-to-GDP gap as a reference point alters the sign of the correlation between output growth and bank capital, producing a strong negative correlation of -0.61. In order to circumvent this issue, real credit growth is employed as an alternative indicator. The use of real credit growth, both as a leading indicator of systemic risk and as a common reference point, seems to moderate credit growth in a sizeable way and output growth to some extent. Finally, the model seems to generate a slightly higher correlation between output and bank capital, confirming that the use of real credit growth, next to having some desirable properties, also seems able to produce results in the model economy that are closely in line with the main objectives of Basel III and its mandate.