Optimizing Asset and Capital Adequacy Management in Banking

Abstract

This paper considers the application of stochastic optimization theory to asset and capital adequacy management in banking. Our study is motivated by new banking regulation that emphasizes risk minimization practices associated with assets and regulatory capital. Our analysis depends on the dynamics of the capital adequacy ratio (CAR), which we compute in a stochastic setting, by dividing regulatory bank capital (RBC) by risk weighted assets (RWAs). Furthermore, we demonstrate how the CAR can be optimized in terms of bank equity allocation and the rate at which additional debt and equity is raised. In either case, the dynamic programming algorithm for stochastic optimization is employed to verify the results. Also, we provide an illustration of aspects of bank management practice in relation to this regulation. Finally, we make a few concluding remarks and discuss possibilities for further research.