Optimal Capital Reserve Strategies for a Bank and its Regulator

Project Member(s): Glover, K.

Start year: 2014

Summary: In this project we will formulate and solve a general model of a deposit taking bank and its regulator. The bank's loans are exposed to default risk and the bank's objective is to maximise the market value of equity by appropriately controlling three core business decisions: the rate at which loans are issued; the amount of dividends paid out to shareholders; and the time at which they may choose to endogenously close down the bank due to insufficient profits. The regulator, on the other hand, has the objective of minimising the overall probability of bank closure by appropriately setting the bank's capital adequacy ratio. Modelling a bank and its regulator in such a way leads to a non-zero-sum Nash equilibrium and requires the solution of a complex joint stochastic optimal control problem.

Publications:

Evatt, GW, Johnson, PV, Glover, KJ & Cheng, M 2015, 'Capital Ideas: Optimal Capital Reserve Strategies for a Bank and Its Regulator'.

Keywords: Capital Requirements, Banking, Real Options, Optimal Control

FOR Codes: Financial Institutions (incl. Banking), Expanding Knowledge in Economics, Calculus of Variations, Systems Theory and Control Theory, Expanding Knowledge in the Mathematical Sciences