Modelling the Basel III capital adequacy and net stable funding ratios for a commercial bank following an optimal investment strategy

Abstract

Commercial banks have a significant impact on a country’s economy as they raise capital, create liquidity by converting their customers’ deposits into loans, and deliver essential services such as loans, certificates of deposits and savings accounts to their clients. As a result, commercial banks are heavily regulated in most countries. The Basel Committee on Banking Supervision (BCBS) introduced an international set of capital standards, known as the Basel Accords, in an attempt to improve the regulation of internationally active banks. These accords resulted from a series of international banking regulatory meetings that established capital and risk manage-ment measurements for internationally active banks. Under the accords, banks are required to maintain a minimum level of capital as a bu˙er to protect their depositors, and the financial market, in the event of severe losses caused by financial risk. The latest of these accords, that is, the Basel III Accord, consists of three key pillars. These are firstly, minimum capital require-ments, secondly, supervisory review, and lastly, market discipline. In this regard, the BCBS introduced, respectively, the Capital Adequacy Ratio (CAR) and the Net Stable Funding Ratio (NSFR). The purpose of the CAR is to determine whether or not an absolute amount of a bank’s capital is adequate when compared to its absolute risk. The purpose of the NSFR, on the other hand, is to determine whether the bank has enough stable funding to cover its long term assets. Furthermore, government regulators aim to maintain the confidence and trust of the general public through the use of a deposit insurance scheme (DIS). In the event of a bank failure, deposit insurance (DI) has the e˙ect of reducing the probability of mass deposit with-drawals. An insuring agent is tasked with estimating a fairly priced premium for DI coverage.