Dynamic modelling of banking activities
Abstract
We investigate the discrete-time dynamics of banking items such as loan demand and supply, deposits, treasury securities, capital and bank value under the influence of macroeconomic factors. These models enable us to formulate an optimization problem subject to cash flow, loan demand, financing and balance sheet constraints. Furthermore, we consider the effect that regulation has on capital adequacy decisions in banking. Our investigation suggests that we are able to maximize the value of a bank for an investor via optimal choices of loan rates, treasury securities, deposits and profits. With the drafting of new banking regulation via the Basel II capital accord, bank regulatory capital and its adequacy has become the subject of much debate. In this thesis, we model and simulate two of the main measures of capital adequacy, namely capital adequacy ratios (CARs) for unweighted and risk-weighted assets. In order to accomplish this, we consider the stochastic dynamics of items such as bank assets, liabilities, regulatory capital and CARs in a Levy process setting. Also, we demonstrate that bank capital dynamics is subject to changes in the demand for loans and is thus procyclical. A further conclusion is that macroeconomic shocks will affect the loan risk-weights via tighter capital constraints when the shock is negative and vice versa. In addition, we provide a descriptive example that illustrates economic aspects of the bank modelling and optimization discussed in the main body of the thesis. Considering such ratios as the CARs in isolation is not very useful for economic analysis. Instead, an important issue related to CARs is their relationship with the economic cycle and consequent effect on financial stability in the banking industry. By way of addressing this topic, we provide computer simulations of such ratios for several countries including some of those that belong to the Organization for Economic Co-operation and Development (OECD). In order to investigate the cyclicality of CARs, we probe the relationship between the output gap (proxy for resource utilization) and the aforementioned ratio. Two of our conclusions are that bank regulatory capital is inclined to be procyclical while CARs tend to be acyclical in most of the countries studied. In addition, we provide a brief analysis of some of the modelling and computation issues arising from the dynamic banking models derived in the main body of the thesis.