Article Detail

Optimal Bank Planning Under Basel III Regulations

Journal 34: Cass-Capco Institute Paper Series on Risk

Sebastian Pokutta, Christian Schmaltz

We provide a modeling framework for banks’ business planning under Basel III. For this purpose, we write banks’ planning as a formal optimization problem where Basel III minimum requirements/ratios enter as constraints. The linear program provides dual variables that are interpreted as compliance cost for each Basel III ratio. We analyze the effects of Basel III on banks’ product mix for a simplified, deterministic two-product case. In what follows, we generalize the model by incorporating parameter uncertainty, adjustment cost, multiple time steps, and products.

As any other company, banks have to determine their optimal business strategy. Regulation plays a crucial role in determining feasible business strategies for a given sector. More precisely, the more regulated a sector is the more restricted are the set of feasible strategies. Banks were already highly regulated before the financial crisis and the number of constraints entering the business planning process was high. As a consequence of the financial crisis, bank regulation has been further ex-tended. These new regulatory requirements, Basel III, enforce an even stricter regulation. Under its predecessor Basel II, banks had to fulfill a single (minimum capital) ratio. The new regulations set forth by Basel III require banks to fulfill four ratios. This complicates banks’ strategic planning. The fact that each product usually affects several ratios at the same time adds further complexity. In order to manage the increased complexity, we propose a formal Basel III optimization model. It seeks to assist bankers in their planning, but it can also help regulators to better predict how banks will adjust their business strategy to the new Basel III requirements. We assume that banks seek to maximize the expected margin income. As products expose banks to risks (loans expose the bank to default risk, deposits expose banks to liquidity risks), any business strategy comes with inherent risks. The risk profile of the optimal business strategy must be within defined risk limits reflecting risk aversion. This risk aversion in turn might be set internally by management or might be given as an external constraint from the regulator. Similar to the classical portfolio optimization, banks maximize their expected returns while limiting inherent risks via constraints.

The recent financial crisis and resulting bailouts with public funds revealed that the chosen business strategies had not been in line with such risk limits. The regulatory response was the publication of a new regulatory reform package (Basel III). In its essence, Basel III narrows down the set of potential business strategies by tightening (regulatory) acceptable risks. Acceptance is defined as minimum buffer-to-risk ratios. In particular, the four Basel III ratios are (1) capital ratio (CR), (2) leverage ratio (LR), (3) liquidity coverage ratio (LCR), and (4) net stable funding ratio (NSFR).

The Basel III framework affects bank’s corporate planning via two rationales. On the one hand, products affect ratios; hence, product changes imply changes in the ratios and might risk the non-compliance with a given ratio. Consequently, the integrated treatment of products and risk profiles in a comprehensive optimization model is necessary. On the other hand, products usually do not only affect a single ratio, but they affect several ratios simultaneously. For example, retail deposits enter the LCR for short-term liquidity risk as a source of risk whereas in the NSFR for illiquid funding risk they appear as a risk buffer. Thus, while a product negatively impacts one ratio it can at the same time positively affect another one. In order to study, model, and optimize business planning under these constraints, an integrated model is necessary.

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