An empirical foundation for calibrating the G-SIB surcharge

As developed by the BCBS, the expected impact framework is the theoretical foundation for calibrating the capital surcharge applied to global systemically important banks (G-SIB surcharge). This paper describes four improvements to the current implementation of the BCBS expected impact framework. We (i) introduce a theoretically sound and an empirically grounded approach to estimating a probability of default (PD) function; (ii) apply density-based cluster analysis to identify the reference bank for each G-SIB indicator; (iii) recalibrate the systemic loss-given-default (LGD) function that determines G-SIB scores, using both the current system based on supervisory judgment and using an alternative system based on CoVaR; and (iv) derive a continuous capital surcharge function to determine G-SIB capital surcharges. Our approach would strengthen the empirical and theoretical foundation of the G-SIB surcharge framework. Moreover, the continuous surcharge function would reduce banks' incentive to manage their balance sheets to reduce systemic capital surcharges, mitigate cliff effects, allow for the lifting of the cap on the substitutability score and penalise growth in the category for all G-SIBs. In addition, our two capital surcharge functions might be used to monitor G-SIBs' capital adequacy and distortions induced by G-SIB surcharges.