Mind the Basel gap

Abstract

The Basel credit gap, the difference between a country’s credit-to-GDP ratio and its estimated long-term trend, is used as a basis for setting countercyclical capital buffers under the Basel III regulatory framework. Using international data from the BIS, we show that the Basel credit gap, estimated by a one-sided HP filter, is nearly equivalent to a naive 16-quarter change in the credit-to-GDP ratio and performs equally well in terms of predicting banking crises. We demonstrate that the near-equivalence between deviations from trend and simple changes occurs when the one-sided HP filter is applied to a unit-root process. The goal of this paper is not to evaluate the performance of the Basel credit gap as an early-warning-indicator, but rather to demonstrate that its estimation method is unnecessarily complicated.