Optimal minimum capital requirement : a profitability and risk management approach

World banking operations shook during the Subprime Mortgage Crisis of 2008. This financial turmoil demonstrated that the international banking regulation, Basel II, had serious shortcomings and was not powerful enough to prevent a banking crisis. Researchers agree that Basel II underestimated the minimum capital requirement (MCR), requiring banks to hold insufficient capital to prevent the last crisis. The present research proposes a risk management framework for MCR calculations. The methodology has three stages: first, the development of a bank profit function (formulated following accounting principles and Profit Function Theory); second, the application of the previous function to derive the bank risk function(following the guidance of Modern Portfolio Theory); finally, the insertion of the latter function as the objective function into a constrained optimization (return on equity constraint). This framework is tested with aggregate data from Canadian banks from the period 2000 to 2010. The optimized capital (KO) is compared to the Basel II Standardized Approach MCR. The findings show that the profit function satisfactorily predicts bank profits, and it is useful development for future work. The risk function, however, does not properly represent the variance of profits. This together with the use of a linear constraint produced KO smaller than Basel II requirements, meaning that, as implemented, this framework cannot replace Basel II. Potential improvements to this framework are identified and proposed for further research. The most important contributions of this research are the development of the bank profit function and a preliminary exploration of this optimization framework to MCR determination. Although, in the current stage of its development, this framework cannot replace Basel II, it presents a new approach to MCR calculations that has the potential to strengthen international banking regulation.Graduate Studies, College of (Okanagan)Graduat