Maike Sundmacher

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

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 Poors 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 banks 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.

A Loan Pricing Model: The Influence of the Lender's Credit Rating

Within the context of a banking institution, economic capital is a statistical measure of the amount of resources required to meet unexpected losses over a specified time period and specified level of certainty. The amount of economic capital held by banks is thus a function of their target insolvency rate (the probability that losses will exceed a certain threshold) and is linked to an implied credit rating. In Australia, for example, the top four banks maintain sufficient economic capital to achieve a target credit rating of AA, which is equivalent to a 0.03% probability of insolvency. The benefits that accrue to banks from a high credit rating, in general, are access to lower cost funds in debt markets and low counterparty margins in swap and foreign exchange markets. However, as banks increase their economic capital to achieve a higher credit rating, the breakeven price on their asset portfolios will rise to the extent that the bank prices these assets to achieve a minimum return on economic capital. Ceteris paribus, the increase in loan rates may make the bank uncompetitive in specific asset markets, depending on the extent to which loan rates and other asset prices are market driven. Thus an increase in the solvency standard for a bank has two opposing effects on bank asset prices. To the extent that a bank prices its assets to achieve a target return on economic capital, an increase in economic capital will increase the net income that the bank needs to earn on its assets, resulting in higher asset prices. Offset against this, is the impact of a higher solvency standard on the cost of funds and market credit spreads for the bank. We propose that a bank that carries a large proportion of its funding book in retail funds may not benefit by targeting a high credit rating, depending on the sensitivity of retail depositors to incremental changes in credit rating. We model this relationship to ascertain an optimal economic capital requirement, varying the relative proportion of retail funds in the funding book. We compare the results of our model to empirical data on bank credit spreads in capital to markets to assess the extent to which an upgrade in the credit rating of a bank will be beneficial to the bank.

Dependence and return distributions during crises : evidence from emerging Asian economies

That asset returns are typically neither independent nor normally distributed is a stylised fact of many financial markets. We examine market returns for a number of emerging Asian nations before and during the Asian crisis and global financial crisis periods and consider how well these are described by the assumptions of normality and independence. Specifically we seek to ask how – if at all – these crises impacted upon the time-series properties of stock market returns in the emerging Asian economies. The first part of the chapter examines the comparative fit of the normal distribution to daily stock market returns for each of the economies under observation. The second part of the chapter follows with an examination of dependence relations in emerging Asian market returns around the crises periods.