An empirical study on the impact of Basel III standards on banks' default risk: The case of Luxembourg

We study how the Basel III regulations, namely the Capital-to-assets ratio (CAR), the Net Stable Funding Ratio (NSFR) and the Liquidity Coverage Ratio (LCR), are likely to impact the banks’ profitabilities (i.e. ROA), capital levels and default. We estimate historical series of the new Basel III regulations for a panel of Luxembourgish banks for a period covering 2003q2 to 2011q3. We econometrically investigate whether historical LCR and NSFR components as well as CAR positions are able to explain the variation in a measure of a bank’s default risk (proxied by Z-Score), and how these effects make their way through banks’ ROA and CAR. We find that the liquidity regulations induce a decrease in average probabilities of default. Conversely, while we find that the LCR has an insignificant impact on banks’ profitability, those banks with higher NSFR (through lower required stable funding, the NSFR denominator) are found to be more profitable. Additionally, we use a model of bank behavior to simulate the banks’ optimal adjustments of their balance sheets as if they had had to adhere to the regulations starting in 2003q2. Then we predict, using our preferred econometric model and based on the simulated data, the banks’Z-Score and ROA. The simulation exercise suggests that basically all banks would have seen a decrease in their default risk if they had previously adhered to Basel III.

Keywords: Basel III, bank default, Z-Score, profitability, ROA, GMM estimator, simulation, Luxembourg.

JEL classification: G21, G28.