Ilse Schoeman

Dynamic modelling of bank profits

A topical issue in financial economics is the development of a stochastic dynamic model for bank behaviour. Under the assumption that the loan market is imperfectly competitive, we investigate the evolution of banking items such as loans, provisions for loan losses and deposit withdrawals, Treasuries and deposits and their relationship with profit. A motivation for studying this type of problem is the need to generalize the more traditional discrete-time models that are being used in the majority of studies that analyse banks and their operational idiosyncracies. An important outcome of our research is an explicit model for bank profit based solely on the stochastic dynamics of bank assets (loans, Treasuries and reserves) and liabilities (deposits). By way of conclusion, we provide a brief discussion of some of the economic aspects of the dynamic bank modelling undertaken in the main body of the article.

Did Bank Capital Regulation Exacerbate the Subprime Mortgage Crisis

This contribution is the second in a series of papers on discrete-time modeling of bank capital regulation and its connection with the subprime mortgage crisis (SMC). The latter was caused by, amongst other things, the downturn in the U.S. housing market, risky lending and borrowing practices, inaccurate credit ratings, credit default swap contracts as well as excessive individual and corporate debt levels. The Basel II Capital Accords primary tenet is that banks should be given more freedom to decide how much risk exposure to permit; a practice brought into question by the SMC. For instance, institutions worldwide have badly misjudged the risk related to investments ranging from subprime mortgage loans to mortgage-backed securities (MBSs). Also, analysts are now questioning whether Basel II has failed by allowing these institutions to provision less capital for subprime mortgage loan losses from highly rated debt, including MBSs. Other unintended consequences of Basel II include the procyclicality of credit ratings and changes in bank lending behavior. Our main objective is to model the dependence of bank credit and capital on the level of macroeconomic activity under Basel I and Basel II as well as its connection with banking behavior for the period before and during the SMC.

Optimal allocation between bank loans and treasuries with regret

The main categories of assets held by banks are loans, Treasuries (bonds issued by the national Treasury), reserves and intangible assets. In our contribution, we investigate the investment of bank funds in loans and Treasuries with the aim of generating an optimal final fund level. Our results take behavioral aspects such as risk and regret into account. More specifically, we apply a branch of optimization theory that enables us to consider a regret attribute alongside a risk component as an integral part of the utility function. In this case, regret-aversion corresponds to the convexity of the regret function and the bank’s preference is assumed to be representable by optimization subject to the utility. In addition, we provide a comparison between risk- and regret-averse banks in terms of optimal asset allocation between loans and Treasuries. A feature of our contribution is that these and other optimization issues are analyzed briefly and, where possible, represented graphically. Furthermore, we comment on the claim that an investment away from loans towards Treasuries is responsible for credit crunches in the banking industry.

A note on the subprime mortgage crisis: dynamic modelling of bank leverage profit under loan securitization

In this brief research article, we consider the financial modelling of the process of mortgage loan securitization that has been a root cause of the ongoing Subprime Mortgage Crisis (SMC). In particular, we suggest a Lévy process-driven model of bank leverage profit that arises from the securitization of a pool of subprime mortgage loans. To achieve this, we develop stochastic models for mortgage loans, mortgage loan losses, credit ratings and mortgage loan guarantees in a subprime context. These models incorporate some of the most important issues related to the SMC and its causes. Finally, we provide a brief analysis of the models developed earlier in our contribution and its relationship with the SMC.

Optimal mortgage loan securitization and the subprime crisis

We analyze the process of mortgage loan securitization that has been a root cause of the current subprime mortgage crisis (SMC). In particular, we solve an optimal securitization problem for banks that has the cash outflow rate for financing a portfolio of mortgage-backed securities (MBSs) and the bank’s investment in MBSs as controls. In our case, the associated Hamilton–Jacobi–Bellman equation (HJBE) has a smooth solution when the optimal controls are computed via a power utility function. Finally, we analyze this optimization problem and its connections with the SMC.

Subprime Risk and Insurance with Regret

This paper investigates some of the risk and insurance issues related to the subprime mortgage crisis. The discussion takes place in a discrete-time framework with a subprime investing bank being considered to be regret and risk averse before and during the mortgage crisis, respectively. In particular, we investigate the banks investment choices related to risky subprime structured mortgage products and riskless treasuries. We conclude that if the bank takes regret into account, it will be exposed to higher risk when the difference between the expected returns on subprime structured mortgage products and treasuries is small. However, there is low-risk exposure when this difference is high. Furthermore, we assess how regret can influence the banks view of a rate of return guarantee from monoline insurers. We find that before the crisis, regret decreased the investment banks preparedness to forfeit on returns when its structured product portfolio was considered to be safe. Alternatively, risk- and regret-averse banks forfeit the same returns when their structured mortgage product portfolio is considered to be risky. We illustrate the aforementioned findings about structured mortgage products and monoline insurance via appropriate examples.

HOW TO MINIMIZE THE EFFECT OF THE GLOBAL FINANCIAL CRISIS ON SOUTH AFRICA

South Africa is a small open economy that is predominantly driven by international developments. There are a great number of specific factors that prevent our economy from achieving its potential. Accordingly, both our business cy cle and outcomes in our financial markets are determined by global events. The global financial crisis (GFC) is an ongoing housing and financial crisis that was triggered by a marked increase in mortgage delinquencies and foreclosures in the U.S. It has had major adverse consequences for banks and financial markets worldwide since it became apparent in 2007. Furthermore, the root of the global financial crisis is financial institutions that underestimat e the business cycle. This is the reason why we consider the output gap (a proxy for the business cycle). In this paper, we evaluate the usefulness of alternative estimates of the out put gap for predicting the business cycle.