A critical evaluation of the sensitivity of a bank’s balance sheet to change when optimizing for capital requirements under Basel

Abstract

The management of a modern bank is a complex task that is becoming increasingly more so due to the inherent complexities of its business and of an ever changing modern financial environment. Recent turmoil in the global financial environment necessitated new regulation, some of which may have a material impact on the structure and management of a bank. The establishment of higher minimum capital buffers for banks to counter the possibility of failing will have a material influence on profitability. Apart from making investment in banks shares less attractive, the regulation may turn out to be bad for global economic growth. In view of the above, the objective of this research was to single out and demonstrate the effect of the minimum capital requirements on the profitability, composition and size of a bank balance sheet. The Simplex algorithm was used to set up a goal programming problem formulation in Excel. Different capital minima was entered in the model and then optimised to observe the effect on the bank balance sheet size, composition and profitability. The research clearly demonstrated that at a capital reserve requirements of 5%, the resulting balance sheet is 190% of the original balance sheet size and at the 25% capital reserve requirement the new balance sheet is merely 57% of the original size. Increasing the reserve requirement from say 5% to 9,5% gives rise to approximately 40% change in balance sheet size, all other things being constant. As the capital reserve requirement is increased from 5% of RWA to 14%, the profit falls from over R60 billion to just over R10 billion. It is clear from the research that banks are very sensitive to the new regulation. It also underlines how difficult it may be for banks to maintain profitability. The changes needed to maintain the profitability, may not be possible/feasible in the South African financial environment. The time is possibly right now for banks to start improving efficiency and developing new innovative low risk high return services and product lines.