How to Make Regulators and Shareholders Happy Under Basel III

Abstract

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, compliant business model. 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. Our approach can be customized to individual board preferences: to achieve compliance (making regulators happy) with a minimum of adjustments and still respecting a target return (making shareholders happy). Our approach needs two standard inputs from controlling: average profit margins per product and adjustment costs to expand or cut back business. To highlight its practicality, the approach is presented as industry study with figures from three representative German savings bank. We show in detail how our approach can deal with the numerous ratio interdependencies inherent in Basel III. Furthermore we discuss how our framework interacts with banks’ internal stress testing model to derive internal Basel III - target ratios and how it can incorporate potential future changes in product profitability.

Keywords: Basel III, Planning, Linear Programming, Capital Ratio, Leverage Ratio, LCR, NSFR

JEL Classification: G21, C61