How to make regulators and shareholders happy under Basel III

In addition to the Basel II capital ratio, Basel III requires banks to respect additional ratios, such as leverage ratio, liquidity coverage ratio and net stable funding ratio. Banks are required to be compliant with all four constraints simultaneously. Our article provides a framework for banks to...

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Bibliographic Details
Published in:Journal of banking & finance 2014-09, Vol.46, p.311-325
Main Authors: Schmaltz, Christian, Pokutta, Sebastian, Heidorn, Thomas, Andrae, Silvio
Format: Article
Language:English
Subjects:
Adjustment costs
Banks
Basel Accords
Basel III
Capital ratio
Capital ratios
Financial services
Funding
LCR
Leverage ratio
Linear programming
NSFR
Rates of return
Regulation
Regulation of financial institutions
Regulatory agencies
Stockholders
Studies
Western Europe
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Summary:In addition to the Basel II capital ratio, Basel III requires banks to respect additional ratios, such as leverage ratio, liquidity coverage ratio and net stable funding ratio. Banks are required to be compliant with all four constraints simultaneously. Our article provides a framework for banks to help their search for an optimal transition from Basel II to Basel III. Recognizing that banks’ return and the four constraints are of linear type, this search can be formulated as a linear program and solved by standard software. Incorporating uncertainty on future defaults, risk weights and withdrawals and formulating the problem as a Chance constrained model does not only yield optimal transition strategies but also determines the internal thresholds for the Basel III-ratios. Our approach needs two standard inputs from controlling: profit margins per product and non-financial adjustment costs to expand or cut back business. The adjustment cost can be used to calibrate the model to the current business mix. This calibration can be done by bank outsiders and allows the model to be used in impact studies to replace ad hoc strategies. To highlight its practicality, we apply our model to a typical German bank with a business mix that complies with Basel II, but not with the Basel III-, capital-, leverage- and net stable funding-ratio. Assuming that its business model is optimal under Basel II, we find that this bank would achieve compliance restructuring its funding side by replacing interbank funding by capital and retail deposits. Additional uncertainty would amplify the magnitude of the changes, but would still affect the same positions. These findings are robust against alternative margin definitions and adjustment cost levels.
ISSN:0378-4266
1872-6372
DOI:10.1016/j.jbankfin.2014.05.031