Bank Performance Optimization Under Regulatory and Internal Constraints: Impact on Shareholder Value, Credit Supply and Risk Profile

Abstract

As regulatory capital constraints in recent years have become more binding and less risk sensitive, banks are evaluating how they need to change their mix of businesses to ensure attractive returns to their shareholders. In this paper we analyze what the optimal choice of business lines is for a bank that maximizes shareholder value when faced with various regulatory as well as internal constraints. Our results show that a bank can largely mitigate the impact of the various constraints on shareholder value by changing the type of businesses in which it is active (shareholder impact), but we find that that there is a material impact on the risk profile of the bank (risk profile impact) as well as the supply of credit to the economy (economic impact). Specifically, our analysis shows: (1) Optimizing shareholder value under a risk-based capital constraint incentivizes the bank to divide its capital across multiple business lines so as to maximize diversification benefits. (2) A binding leverage ratio constraint incentivizes the bank to allocate its capital to the riskiest business line(s), thereby increasing and becoming more concentrated in the risk it takes (risk profile impact). Combining this with a risk-based capital constraint does not eliminate this incentive but limits the amount that can be invested in riskier assets. As a consequence, the amount of credit that will be provided to the economy (economic impact) will be lower than without a leverage ratio constraint. (3) An earnings volatility constraint, which is typically an internal constraint, incentivizes the bank to maximize diversification benefits as in (1), but at the same time to maintain more capital per unit of risk than in (1) so as to lower the volatility of the return on equity. (4) Subsidiarization and ring-fencing restrict a bank to achieve diversification benefits, thereby incentivizing it to focus on a single or a few business lines in which it has the greatest competitive edge. Many banks face most, if not all, of the above constraints. This incentivizes banks to become more specialized in core activities, focus on more risky activities and restrict lending. This results in less diversified banks that are more vulnerable to a downturn in their chosen markets. The results of our analysis should be of value for policy makers, regulators and bank managers.