The Impact of Economic Capital on the Optimal Funding Equation for a Bank

35 Pages Posted: 15 Feb 2007

See all articles by Guy Ford

Guy Ford

Macquarie University - Graduate School of Management

Maike Sundmacher

Date Written: November 2004

Abstract

This paper develops a framework for examining the impact of changes in the solvency standard of a bank (target credit rating) on the pricing of bank assets. We show that the decision of a bank to increase its solvency standard increases the price of bank assets to the extent that a bank prices its assets in order to earn a minimum return on target economic equity. However, a higher credit rating should also reduce the cost of rated-debt that a bank uses to fund its assets. We develop a loan pricing model to assess the breakeven point at which the impact of a higher solvency standard on bank asset prices is matched by the reduction in the cost of rated-debt, and compare our theoretically-derived results to actual credit spreads on bank debt rated by Standard and Poor's in order to determine the if there is an optimal credit rating for a bank. Our model uses a beta distribution to derive the capital multiplier necessary to determine the target economic equity for the bank. We vary the proportion of rated-debt funding the bank's assets. We also assess the impact of changes in the hurdle rate used to price bank assets, where the hurdle rate is varied in line with changes in the leverage of the bank. Our paper shows how target credit rating, funding mix and hurdle rates interact to determine the optimal asset mix for a bank. The paper also demonstrates the significance of the distribution assumptions used to determine the economic capital for a bank.

Keywords: Loan pricing, regulatory capital, economic capital, credit rating

JEL Classification: G21

Suggested Citation

Ford, Guy and Sundmacher, Maike, The Impact of Economic Capital on the Optimal Funding Equation for a Bank (November 2004). Available at SSRN: https://ssrn.com/abstract=963233 or http://dx.doi.org/10.2139/ssrn.963233

Guy Ford

Macquarie University - Graduate School of Management ( email )

99 Talavera Road
Sydney, NSW 2113
Australia
+61-2-9850-7813 (Phone)
+61-2-9850-9019 (Fax)

No contact information is available for Maike Sundmacher

Register to save articles to
your library

Register

Paper statistics

Downloads
366
rank
78,785
Abstract Views
1,594
PlumX Metrics