Output Floors

We examine various implementation issues and challenges related to the calibration of output floors in setting minimum bank capital requirements under the finalized version of the Basel III capital accord. In our view, the main raison d'être of output floors is to limit the capital savings enjoyed by large banks due to regulatory arbitrage under the internal model paradigm. We consider regulatory arbitrage through the bank's incentive to optimize its grading system in order to lower as much as possible the capital requirement given the structure of its asset portfolio in terms of internal ratings and default probabilities. Based on a fictional portfolio of French SMEs observed over a full business cycle, we conduct a counterfactual analysis in order to compare the effect of the output floor implemented with respect to various benchmarks: a Basel I-style benchmark and two versions of the revised standardized approach. Our results show that a more risk-sensitive benchmark is likely to reduce the effect of the output floor on the "extra" RWA and, in fine, on the minimum capital requirement. Otherwise stated, the lower the gap between the internally-derived RWA, subject to regulatory capital arbitrage, and its standardized approach yardstick, the higher the probability that the output floor mechanism becomes less binding or even irrelevant.