Hindawi Publishing Corporation

Journal of Applied Mathematics

Volume 2014, Article ID 723873, 11 pages
http://dx.doi.org/10.1155/2014/723873

Research Article
An Optimal Portfolio and Capital Management Strategy
for Basel III Compliant Commercial Banks
Grant E. Muller and Peter J. Witbooi
University of the Western Cape, Private Bag X17, Bellville 7535, South Africa
Correspondence should be addressed to Peter J. Witbooi; [email protected]
Received 3 October 2013; Accepted 5 January 2014; Published 19 February 2014
Academic Editor: Francesco Pellicano
Copyright 2014 G. E. Muller and P. J. Witbooi. This is an open access article distributed under the Creative Commons Attribution
License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.
We model a Basel III compliant commercial bank that operates in a financial market consisting of a treasury security, a marketable
security, and a loan and we regard the interest rate in the market as being stochastic. We find the investment strategy that maximizes
an expected utility of the banks asset portfolio at a future date. This entails obtaining formulas for the optimal amounts of bank
capital invested in different assets. Based on the optimal investment strategy, we derive a model for the Capital Adequacy Ratio
(CAR), which the Basel Committee on Banking Supervision (BCBS) introduced as a measure against banks susceptibility to failure.
Furthermore, we consider the optimal investment strategy subject to a constant CAR at the minimum prescribed level. We derive a
formula for the banks asset portfolio at constant (minimum) CAR value and present numerical simulations on different scenarios.
Under the optimal investment strategy, the CAR is above the minimum prescribed level. The value of the asset portfolio is improved
if the CAR is at its (constant) minimum value.

1. Introduction
Successful bank management can be achieved by addressing
four operational concerns. Firstly, the bank should be able
to finance its obligations to depositors. This aspect of bank
management is called liquidity management. It involves the
bank acquiring sufficient liquid assets to meet the demands
from deposit withdrawals and depositor payments. Secondly,
banks must engage in liability management. This aspect
of bank management entails the sourcing of funds at an
acceptable cost. Thirdly, banks are required to invest in assets
that have a reasonably low level of risk associated with them.
This process is referred to as asset management. It aims to
encourage the bank to invest in assets that are not likely to
be defaulted on and to adopt investment strategies that are
sufficiently diverse. The fourth and final operational concern
is capital adequacy management. Capital adequacy management involves the decision about the amount of capital the
bank should hold and how it should be accessed. From a
shareholders perspective, utilizing more capital will increase
asset earnings and will lead to higher returns on equity.
From the regulators perspective, banks should increase their
buffer capital to ensure the safety and soundness in the case

where earnings may end up below an expected level. In this

paper, we address problems associated with asset and capital
adequacy management.
The Basel Committee on Banking Supervision (BCBS)
regulates and supervises the international banking industry
by imposing minimal capital requirements and other measures. The 1998 Basel Capital Accord, also known as the
Basel I Accord, aimed to assess the banks capital in relation
to its credit risk, or the risk of a loss occurring if a party
does not fulfill its obligations. The Basel I Accord launched
the trend toward increasing risk modeling research. However, its oversimplified calculations and classifications have
simultaneously called for its disappearance. This paved the
way for the Basel II Capital Accord and further agreements
as the symbol of the continuous refinement of risk and
capital. The 2004 (revised) framework of the Basel II Capital
Accord (see [1]) laid down regulations seeking to provide
incentives for greater awareness of differences in risk through
more risk-sensitive minimum capital requirements based
on numerical formulas. The Total Capital Ratio or Capital
Adequacy Ratio (CAR) (see for instance [26]) measures
the amount of the banks capital relative to its amount of
credit exposures. Internationally, a standard has been adopted

Journal of Applied Mathematics

that requires banks to adhere to minimum levels of capital

requirements. By complying with minimum capital levels,
banks are guaranteed the ability to absorb reasonable levels
of losses before becoming insolvent. Thus, CARs ensure the
safety and stability of the banking system. Under the Basel
II Accord, banks were required to maintain a CAR, that
is, a ratio of total bank capital to total risk-weighted assets
(TRWAs), with a minimum value of 8%.
In response to the 2007-2008 financial crisis, the Basel
Committee on Banking Supervision (BCBS) introduced a
comprehensive set of reform measures known as the Basel
III Accord. The Basel III Accord is aimed at improving the
regulation, supervision, and risk management within the
banking sector and is part of the continuous effort made
by the BCBS to enhance the banking regulatory framework.
The Basel III Accord builds on the Basel I and II documents
and seeks to improve the banking sectors ability to deal with
financial and economic stress, improve risk management, and
strengthen the banks transparency. The focus of the Basel III
Accord is to foster greater resilience at the individual bank
level in order to reduce the risk of system wide shocks. In this
regard, the Basel III Accord contains changes in the following
areas: (i) augmentation in the level and quality of capital;
(ii) introduction of liquidity standards; (iii) modifications in
provisioning norms; (iv) introduction of a leverage ratio. For
a detailed discussion on the aforementioned enhancements
in the Basel III Accord over the Basel II Accord, see the paper
[7] of Jayadev or the book [8] of Petersen and MukuddemPetersen.
In our paper, we are concerned with the level of bank
capital. Thus we study the Total Capital Ratio or CAR which,
if denoted by , is defined as
=

.
rw

(1)

In the expression for the CAR above, denotes the total

bank capital and rw the TRWAs of the bank. Under Basel
III rules, the minimum prescribed value of the banks CAR
remains unchanged at 8%. However, banks are now required
to hold a Capital Conservation Buffer (CCB) of 2.5% and
Countercyclical Buffer Capital (CBC) in the range of 0
2.5%. The CCB ensures that banks can absorb losses without
breaching the minimum capital requirement and are able to
carry on business even in a downturn without deleveraging.
The CBC is a preemptive measure that requires banks to
build up capital gradually as imbalances in the credit market
develop. It may be in the range of 02.5% of risk-weighted
assets which could be imposed on banks during periods of
excess credit growth. There is also a provision for a higher
capital surcharge on systematically important banks (see [7,
8]).
In finance, the stochastic optimal control method is a
popular optimization technique and was used for the first
time by Merton [9, 10]. This technique involves solving
the Hamilton-Jacobi-Bellman (HJB) equation arising from
dynamic programming under the real world probability
measure. Examples of the application of this technique in
the banking literature can be the papers by MukuddemPetersen and Petersen [11], Mukuddem-Petersen et al. [12],

Mukuddem-Petersen et al. [13], and Gideon et al. [14] for

instance. In their paper, Mukuddem-Petersen and Petersen
[11] studied a problem related to the optimal risk management of banks in a stochastic setting. The aforementioned
authors minimized market and capital adequacy risk that
respectively involves the safety of the securities held and
the stability of sources of funds. In this regard, the authors
suggested an optimal portfolio choice and rate of bank capital
inflow that will keep the loan level as close as possible to
an actuarially determined reference process. In the paper
[12] by Mukuddem-Petersen et al., the authors solved a
stochastic maximization problem that is related to depository
consumption and banking profit on a random time interval.
In particular, they showed that it is possible for a bank
to maximize its expected utility of discounted depository
consumption on a random time interval, [, ], and its final
profit at time . In the paper [13] of Mukuddem-Petersen
et al. (see also the book of Petersen et al. [15]) the authors
analyzed the mortgage loan securitization process which
was the root cause of the subprime mortgage crisis (SMC)
of 2008. The authors considered a bank that has the cash
outflow rate for financing a portfolio of mortgage-backed
securities (MBSs) and studied an optimal securitization
problem with the investment in the MBSs as controls. Gideon
et al. [14] quantitatively validated the new Basel III liquidity
standards as encapsulated by the net stable funding ratio. By
considering the inverse net stable funding ratio as a measure
to quantify the banks prospects for a stable funding over
the period of a year, they solved an optimal control problem
for a continuous-time inverse net stable funding ratio. More
specifically, the authors made optimal choices for the inverse
net stable funding targets in order to formulate its cost. The
latter was achieved by finding an analytical solution for the
value function.
In theoretical physics, the Legendre transform is commonly used in areas such as classical mechanics, statistical
mechanics, and thermodynamics. The Legendre transform
also has its uses in mathematics of finance. For instance in
pension fund optimization problems, the Legendre transform
is generally applied to transform nonlinear HJB PDEs arising
from the optimal control technique to linear PDEs for which
it is easier to find a closed form solution. Authors who have
applied the Legendre transform in pension funds are Xiao et
al. [16] on the constant elasticity of variance (CEV) model
for a defined contribution pension plan and the Legendre
transform-dual solutions for annuity contracts, Gao [17] on
the stochastic optimal control of pension funds, Gao [18] on
the optimal investment strategy for annuity contracts under
the CEV model, Gao [19] on the extended CEV model and the
Legendre transform-dual-asymptotic solutions for annuity
contracts, and Jung and Kim [20] on the optimal investment
strategies for the hyperbolic absolute risk aversion (HARA)
utility function under the CEV model.
In our contribution, the issues of asset portfolio and capital adequacy management for Basel III compliant commercial
banks are addressed in a continuous-time setting. More
specifically, our goal is to maximize an expected utility of a
commercial banks asset portfolio at a future date. We assume
that the interest rate in the market is stochastic and that the

Journal of Applied Mathematics

asset portfolio consists of a treasury security, a marketable
security, and a loan. We take the stochastic optimal control
approach and arrive at a nonlinear second-order PDE for the
value function for which it is difficult to find a solution. Our
choice of asset portfolio is based on the portfolio of Gao [17].
In a pension fund setting, Gao [17] solved the optimization
problem in question using the Legendre transform and dual
theory. With our optimization problem similar to that in
[17], we evoke the results of Gao. Based on the investment
strategy that solves our optimization problem we derive a
model for the Total Capital Ratio or CAR of the bank in terms
of the optimal amounts of bank capital invested in the assets.
Furthermore, we assume that the bank follows the optimal
investment strategy while simultaneously maintaining its
CAR at the fixed level of 8%. We obtain a formula for
the banks asset portfolio into which is incorporated the
restriction on the CAR. By means of numerical simulations
we characterize the optimal investment strategy by presenting
graphically the optimal proportions of capital invested in
the banks assets. In addition, we simulate and graphically
illustrate the behaviours of the CAR and the modified asset
portfolio subject to the optimal investment strategy. To our
knowledge, a study as described above has not been done for
a commercial Basel III compliant bank.
The layout of the rest of our paper is as follows. In
Section 2 we present some general banking theory. More
specifically, we describe the banks assets, liabilities, and
capital, all of which comprise its stylized balance sheet. We
introduce the financial market in Section 3. Here we specify
models for the stochastic interest rate in the market and
the assets and asset portfolio of the bank. In Section 4 we
formulate the optimization problem and present the optimal
solution. In this section we also present the bank capital
model relevant to the optimization problem. The formula
for the CAR is derived in Section 5. We simulate graphically
the optimal investment proportions of capital invested in the
assets as well as the dynamics of the CAR. Section 6 is devoted
to the derivation of the asset portfolio pertaining to a constant
CAR. In this section we also provide a simulation of the
modified asset portfolio obtained via the optimal investment
strategy and restricted CAR. We conclude the paper with
Section 7.

2. The Commercial Banking Model

We consider a complete and frictionless financial market
which is continuously open over a fixed time interval [0, ].
Throughout, we assume that we are working with a probability space (, F, P), where P is the real world probability.
We assume that the Brownian motions that appear in the
dynamics of the bank items are defined on the probability
space (, F, P) and that the filtration (F())0 satisfies the
usual conditions.
To understand the operation and management of commercial banks, we study its stylized balance sheet, which
records the assets (uses of funds) and liabilities (sources of
funds) of the bank.

3
Bank capital fulfills the role of balancing the assets and
liabilities of the bank. A useful way, for our analysis, of
representing the balance sheet of the bank is as follows:
() + () + () = () + () + () ,

(2)

where , , , , , and represent the values of treasuries,

securities, loans, deposits, borrowings, and capital, respectively. Each of the variables above is regarded as a function
R+ R+ .
In order for a commercial bank to make a profit, it
is important that the bank manages the asset side of its
balance sheet properly. The latter is determined by two
factors, namely, the amount of capital available to invest it
has and the attitude it has toward risk and return. The bank
must therefore allocate its capital optimally among its assets.
Below we explain each of the items on the balance sheet of a
commercial bank.
The term reserves refers to the vault cash of the bank plus
the compulsory amount of its money deposited at the central
bank. Reserves are used to meet the day-to-day currency
withdrawals by its customers. Securities consist of treasury
securities (treasuries) and marketable securities (securities).
Treasuries are bonds issued by national treasuries in most
countries as a means of borrowing money to meet government expenditures not covered by tax revenues. Securities, on
the other hand, are stocks and bonds that can be converted
to cash quickly and easily. Loans granted by the bank include
business loans, mortgage loans (land loans), and consumer
loans. Consumer loans include credit extended by the bank
for credit card purchases. Mortgages are long term loans used
to buy a house or land, where the house or land acts as
collateral. Business loans are taken out by firms that borrow
funds to finance their inventories, which act as collateral for
the loan. A loan which has collateral (a secured loan) has a
lower interest rate associated with it compared to a loan which
has no collateral (unsecured loans).
Bank capital is raised by selling new equity, retaining
earnings, and by issuing debt or building up loan-loss
reserves. The banks risk management department is usually
responsible for calculating its capital requirements. Calculated risk capital is then approved by the banks top executive
management. Furthermore, the structure of bank capital
is proposed by the Finance Department and subsequently
approved by the banks top executive management. The
dynamics of bank capital is stochastic in nature because
it depends in part on the uncertainty related to debt and
shareholder contributions. In theory, the bank can decide on
the rate at which debt and equity are raised.
Under the Basel III Accord (see [21]) the banks capital ,
also referred to as total bank capital, has the form
() = T1 () + T2 () ,

(3)

where T1 () and T2 are Tier 1 and Tier 2 capital, respectively.

Tier 1 capital consists of the sum of Common Equity Tier
1 capital and Additional Tier 1 capital. Common Equity Tier
1 capital is defined as the sum of common shares issued by
the bank that meet the criteria for classification as common

Journal of Applied Mathematics

shares for regulatory purposes, stock surplus resulting from

the issue of instruments included in Common Equity Tier 1
capital, retained earnings, other accumulated comprehensive
income and other disclosed reserves, common shares issued
by consolidated subsidiaries of the bank and held by third
parties that meet the criteria for inclusion in Common Equity
Tier 1 capital, and regulatory adjustments applied in the
calculation of Common Equity Tier 1 capital. Additional Tier
1 capital is the sum of instruments issued by the bank that
meet the criteria for inclusion in Additional Tier 1 capital
(and are not included in Common Equity Tier 1 capital), stock
surplus resulting from the issue of instruments included in
Additional Tier 1 capital, instruments issued by consolidated
subsidiaries of the bank and held by third parties that meet
the criteria for inclusion in Additional Tier 1 capital and are
not included in Common Equity Tier 1 capital, and regulatory
adjustments applied in the calculation of Additional Tier 1
capital.
Tier 2 capital is defined as the sum of the following
elements: instruments issued by the bank that meet the
criteria for inclusion in Tier 2 capital (and are not included
in Tier 1 capital), stock surplus resulting from the issue of
instruments included in Tier 2 capital, instruments issued by
consolidated subsidiaries of the bank and held by third parties
that meet the criteria for inclusion in Tier 2 capital and are
not included in Tier 1 capital, certain loan-loss provisions,
and regulatory adjustments applied in the calculation of Tier
2 capital.
Deposits refer to the money that the banks customers
place in the banking institution for safekeeping. Deposits
are made to deposit accounts at a banking institution, such
as savings accounts, checking accounts, and money market
accounts. The account holder has the right to withdraw any
deposited funds, as set forth in the terms and conditions of
the account. Deposits are considered to be the main liabilities
of the bank.
The term borrowings refers to the funds that commercial
banks borrow from other banks and the central bank.

3. The Financial Market Setting

0 (0) = 1.

(4)

The dynamics of the short rate process, (), is given by

the stochastic differential equation (SDE)
() = ( ()) () ,

()
= () + 1 ( () + 1 )
()

(6)

+ 2 ( () + 2 ) ,
with (0) = 1 and 1 , 2 (resp., 1 , 2 ) being constants (resp.,
positive constants) as in Deelstra et al. [24].
The third asset is a loan to be amortized over a period
[0, ] whose price at time 0 is denoted by (). We assume
that its dynamics can be described by the SDE
()
= () + ( , ()) ( () + 2 ) . (7)
()
We now model the asset portfolio of the bank. Let ()
denote the value of the asset portfolio at time [0, ]. The
dynamics of the asset portfolio are described by
() = ()

0 ()
()
+ ()
0 ()
()

()
+ () ,
+ ()
()

(8)

where (), (), and () denote the amounts of capital

invested in the two risky assets (security and loan) and in
the riskless asset (treasury), respectively. Making use of the
models for 0 (), (), and (), we can rewrite (8) as
() = { () () + () [ 1 1 + 2 2 2 ]
+ () 2 ( , ()) }
+ () 1 ()+( () ( , ())

We assume that it is possible for the bank to continuously

raise small levels of capital at a rate (). The bank is
assumed to invest its capital in a market consisting of at
least two types of assets (treasury and security) which can be
bought and sold without incurring any transaction costs or
restriction on short sales. It is assumed that the bank invests
in a third asset, namely, a loan.
The first asset in the financial market is a riskless treasury.
We denote its price at time by 0 () and assume that its
dynamics evolve according to the equation
0 ()
= () ,
0 ()

for 0 and where = 1 () + 2 . The coefficients , ,

1 , and 2 , as well as the initial value (0), are all positive real
constants. The above dynamics recover, as a special case, the
Vasicek [22] (resp., Cox et al. [23]) dynamics when 1 (resp.,
2 ) is equal to zero. The term structure of the interest rates is
affine under the aforementioned dynamics.
The second asset in the market is a risky security whose
price is denoted by (), 0. Its dynamics are given by the
equation

(5)

+ () 2 ) ()+ () .
(9)

4. The Portfolio Problem and

Optimal Solution
In this section we formulate the optimal control problem
associated with an influx of capital at a rate
() = () ,

(0) > 0.

(10)

We derive the HJB equation for the value function and we

present the optimal solution from the methodology of Gao
[17].
We wish to choose a portfolio strategy in order to
maximize the expected utility of the banks asset portfolio at
a future date > 0. Mathematically, the stochastic optimal
control problem can be stated as follows.

Journal of Applied Mathematics

Problem 1. Our objective is to maximize the expected utility

of the banks asset portfolio at a future date > 0. Thus we
must
maximize

The first-order maximizing conditions for the optimal

strategies and are

( , ) = E ( ( ())) ,

subject to () = ( ()) () ,

( 1 1 + 2 2 2 )
(11)

If we put (15) into (14), we obtain a PDE for the value function
:

+ ()] + () 1 ()
+ ( ) +

+ ( () ( , ())

(0) = 0 ,

with 0 , and where (0) = 0 and (0) = 0 denote

the initial conditions of the optimal control problem.
In this paper we describe the banks objective with a
logarithmic utility function; that is,
() = ln ,

with > 0.

(12)

We note that the utility function () is strictly concave up and

satisfies the Inada conditions (+) = 0 and (0) = +.
By using the classical tools of stochastic optimal control, we
define the value function
(13)
0 < < .
The value function can be considered as a kind of utility
function. The marginal utility of the value function is a
constant, while the marginal utility of the original utility
function () decreases to zero as (see Kramkov
and Schachermayer [25]). The value function also inherits the
convexity of the utility function (see Jonsson and Sircar [26]).
Moreover, it is strictly convex for < even if () is not.
The maximum principle leads to the HJB equation (see
Duffie [27]):
+ ( )
+ [ + ( 1 1 + 2 2 2 ) + 2 + ]
+

2
1 2 2
2
[1 + ( + 2 ) ] +
2
2

( +

2 2 )

(14)

= 0,

where we have suppressed the time variable . In the HJB

equation above, , , , , , and denote partial
derivatives of first and second orders with respect to time,
interest rate, and asset portfolio.

(16)

The problem is to solve (16) for the value function and

replace it in (15) in order to obtain the optimal investment
strategy. The above equation is a nonlinear second-order
PDE, which is very difficult to solve. The solution to this
particular problem was derived in a pension fund setting by
Gao [17], who did so by employing the Legendre transform
and dual theory. We present the optimal solution from Gao
[17] in Remark 2 below.
At this point we shall specify a particular candidate for the
function appearing in (7). We assume to take the form

(, , ) = sup E ( ( () | () = , () = )) ,
,

2
+ ( + )
2

( )
2 2
1 2
= 0.
2
2

+ () 2 ) () ,
(0) = 0 ,

(15)

( 2 1 ) + 1
.
= 1 2
1

() = [ () () + ()

+ () 2 ( , ())

1
,
1

( , ()) = ( )

(17)

2 ( 1)
,
( 1 2 ) + ( + 1 2 )

(18)

with
() =

= ( 1 2 ) + 21 .
Remark 2. The solution of Problem 1 is obtained by solving
(16) in terms of and substituting the result into (15). The
optimal solution is as follows.
The optimal amount of bank capital invested in the loan
is
=

( 2 1 1 2 )
1
() [
[

( 1 2 2 1 ) |

1
| ( ) (1 | )

],
]

(19)

Journal of Applied Mathematics

or if we denote the optimal proportion of capital invested in

the loan by , then we can write
=

( 2 1 1 2 )
1

rw ()
= [0.2 () ( () + 1 1 + 2 2 2 )

() [ ( 1 2 2 1 ) |

1
[
+

| ( ) (1 | )

+ 0.2 () 1 ()
+ [0.2 () 2

].
]

1
( + () | ) ,
1

+0.5 () ( , ())] () .

(21)

or if denotes the optimal proportion of capital invested in

the security, then
=

1 () |
+
.
1

(22)

According to the above models, we may write the optimal

amount of capital invested in the treasury as
=

(23)

= 1 ,

(24)

and hence

In the proof of the proposition below we make use of Itos

Lemma and Itos Product Rule, for which we refer to the book
[28] by ksendal.
Proposition 4. With the dynamics of the total bank capital,
(), given by the ODE in (10), and with the dynamics of the
TRWAs, , given by (26), we can write the dynamics of the
Total Capital Ratio or CAR at time as
() = 1 +

3
()
[(2 +
)
2 ()

()
(1 () + 2 ())] ,
(27)

1 =

()
,
()

2 = 0.2 () ( () + 1 1 + 2 2 2 )
+ 0.5 () ( () + ( , ()) 2 ) + () ,

5. The Total Capital Ratio

We now proceed to derive the dynamics of the Total Capital

Ratio (CAR). In order to do so, we first derive the dynamics of
the TRWAs of the bank. In addition, we simulate the optimal
proportions of bank capital invested in the assets and the CAR
at the end of this section. The dynamics of the TRWAs and
CAR are, respectively, derived in the remark and proposition
below. We still assume that the bank capital evolves according
to (10).
Remark 3. Suppose that, at time , the TRWAs can be
described by the SDE
()
()
+ 0.2 ()
rw () = 0 () 0
0 ()
()

(26)

where

where is the optimal proportion of capital invested in the

treasury. The expression denotes a continuous annuity of
duration .

()
+ 0.5 ()
+ () ,
()

+ 0.5 () ( () + ( , ()) 2 ) + ()]

(20)

Furthermore, the optimal amount of capital invested in the

security is given by
=

III Accord. By simplifying (25), the expression for rw ()

reduces to the following:

(25)

where 0, 0.2, and 0.5 are the risk-weights associated with,

respectively, the treasury, security, and loan under the Basel

3 = (0.2 () 1 ) + (0.2 () 2
2

+ 0.5 () ( , ())) ,
1 = 0.2 () 1 ,
2 = 0.2 () 2 + 0.5 () ( , ()) .
(28)
Proof. We mainly use Itos general formula to derive (27). Let
(rw ()) = 1/(rw ()). Then by Itos Lemma,
(rw ())
= (rw ()) + (rw ()) rw ()
1
2
+ (rw ()) [rw ()]
2
= 0

rw () [rw ()]
+
2 ()
3 ()
rw
rw

Journal of Applied Mathematics

= {

1
[0.2 () ( () + 1 1 + 2 2 2 )
()

= 1 + () [(

2
rw

+ 0.5 () ( () + ( , ()) 2 )

1
1
1
2 + 3
3 ) 2
rw ()
rw ()
()

2
rw

(1 () + 2 ())]

1
2
[(0.2 () 1 )
+ ()] + 3
rw ()

= 1 +

+ (0.2 () 2

3
()
[(2 +
)
2
rw ()
rw ()

+ 0.5 ()

(1 () + 2 ())] ,
(31)

( , ()))2 ]}

where we have defined

1
[0.2 () 1 ()
2 ()
rw
+ (0.2 () 2

2 = 0.2 () ( () + 1 1 + 2 2 2 )

+ 0.5 () ( , ())) ()] .

(29)
Let () denote the CAR at time for [0, ]. Then by
definition (see (1)), we can write () as
() =

()
,
rw ()

1 =

()
= () (rw ()) .
rw ()

+ 0.5 () ( () + ( , ()) 2 ) + () ,
2

3 = (0.2 () 1 )

+ (0.2 () 2 + 0.5 () ( , ())) ,

(30)

We apply Itos Product Rule to () = ()(rw ()) to find

an expression for ():

1 = 0.2 () 1 ,
2 = 0.2 () 2 + 0.5 () ( , ()) .
(32)
This concludes the proof.

()

We provide a numerical simulation in order to characterize the behaviour of the CAR, . We assume that the
interest rate follows the CIR dynamics (2 = 0) and that the
financial market consists of a treasury, a security, and a loan.
Furthermore, we consider an investment horizon of = 10
years and that capital is raised at the fixed rate of = 0.13.
The rest of the parameters of the simulation are

= () (rw ()) + () (rw ())

=

()
+ () (rw ())
rw ()

()

rw ()

+ () {{

1
[0.2 () ( () + 1 1 + 2 2 2 )
()

2
rw

+ 0.5 () ( () + ( , ())
1
2 )+ ()]+ 3
rw ()
2

[(0.2 () 1 ) +(0.2 () 2 + 0.5

2

() ( , ())) ]}

1
[0.2 () 1 ()
2 ()
rw
+ (0.2 () 2 + 0.5 ()
( , ())) ()]}

= 0.0118712,
1 = 0.00118712,
1 = 0.045,

= 0.0339,
1 = 0.1475,

2 = 0.295,

(33)

2 = 0.09

with initial conditions

(0) = 1,
(0) = 1.5,

(0) = 0.075,

rw (0) = 1.4,

(0) = 0.08.

(34)

In Figure 1 we characterize the optimal investment

strategy that solves Problem 1 by simulating the optimal
proportions of capital invested in the assets. The optimal
investment strategy depicted in Figure 1 leads to the CAR
in Figure 4. By diversifying its asset portfolio according to
the optimal strategy illustrated by Figure 1, we note that the
bank maintains its CAR in such a manner that it is above
the minimum required level of 8%. Since the bank complies
with the minimum required ratio of total capital to TRWAs

Journal of Applied Mathematics

1

0.8

0.6

0.4

0.2

0.2
0.4

2
0

Treasury
Security

4
6
Time (years)

10

Loan

6
Time (years)

10

Optimal asset portfolio

Figure 1: A simulation of the optimal proportions (), (), and

() of bank capital invested in the assets, given a constant stream
of capital inflow.

Figure 2: A simulation of (), the optimal asset portfolio, given a

constant stream of capital inflow.

3.2

as imposed by the Basel III Accord, it is guaranteed the

ability to absorb reasonable levels of losses before becoming
insolvent over the 10-year period. We also simulate the
optimal asset portfolio and TRWAs in Figures 2 and 3,
respectively. An interesting observation is that the TRWAs
attain its maximum at the end of the investment period under
consideration. This is due to the optimal amounts of bank
capital, and , invested, respectively, in the security and
loan being embedded in the formula for the TRWAs in (25).
The volatile natures of the quantities simulated above are
consistent with the stochastic variables used throughout the
paper.

3
2.8
2.6
2.4
2.2
2
1.8
1.6
1.4

6. The Asset Portfolio for a Constant CAR

10

Time (years)

We now set out to modify the asset portfolio of Problem 1 in

such a way as to maintain the Total Capital Ratio or CAR at
a constant rate of 8%. To this end we need to have the bank
capital () to be stochastic. We assume that the stochastic
term is sufficiently small in order to use the solution of
Problem 1 as a reasonable approximation. The actual form
of () is deduced from the identity () = 0.08rw .
The formula for the asset portfolio is given in Remark 5
below.
Remark 5. At time the dynamics of the asset portfolio,
(), of the bank investing its capital according to the
optimal investment strategy from Problem 1 and, in addition,
maintaining its CAR at 8%, can be written as
() = 1 + 2 () + 3 () ,

(35)

TRWAs

Figure 3: A simulation of the total risk-weighted assets, rw (), given

a constant stream of capital inflow.

where
1 = ( () () ()) ()
117
+
() ( () + 1 1 + 2 2 2 )
115
24
+ () ( () + ( , ()) 2 ) ,
23
117
2 =
() 1 ,
115
117
24
3 =
() 2 + () ( , ()) .
115
23

(36)

Journal of Applied Mathematics

0.16

117
24
117
() 1 + [
() 2 + ()
115
115
23

0.15

( , ())] .

0.14

(40)
0.13

By writing the coefficients of , (), and () of the

above expression, respectively, as 1 , 2 , and 3 , the asserted
expression for () emerges.
We now characterize the behaviour of the modified asset
portfolio given by (35). We consider an interest rate following
the CIR dynamics (2 = 0) and an investment horizon of =
10 years. A capital contribution rate of = 0 is considered,
while the rest of the simulation parameters are

0.12
0.11
0.1
0.09
0.08

4
6
Time (years)

10

= 0.0118712,

Total Capital Ratio

Figure 4: A simulation of (), the Total Capital Ratio, given a

constant stream of capital inflow.

1 = 0.00118712,
1 = 0.045,

= 0.0339,
1 = 0.1475,

2 = 0.295,

(41)

2 = 0.09

with initial conditions

The argument for this remark goes as follows. From the
condition () = ()/rw () = 0.08, we have ()/0.08 =
rw (). By substituting ()/0.08 for the left hand side of
(25) and replacing the () of (25) by (), we obtain
(

()
()
1
+ 0.5 ()
.
1) () = 0.2 ()
0.08
()
()
(37)

Solving () in terms of ()(()/()) and ()(()/

()) yields
() =

1
()
()
2
+ ()
.
()
115
()
23
()

(38)

(0) = 1,
(0) = 1.5,

(0) = 0.075,
(0) = 1.5.

(42)

For a bank that diversifies its asset portfolio according

to the solution of Problem 1 and maintains its CAR at a
constant value of 8%, we simulate the modified version of
its asset portfolio in Figure 5. In this simulation we control
the bank capital () as in Figure 6 during the 10-year
investment period. We note that the growth of the modified
asset portfolio given by (35) is much slower compared to
the original asset portfolio of Problem 1. For the specific
simulation shown the modified asset portfolio is maximal at
time = 10 years.

Substituting the above expression as the () of (8) gives

() = ()

0 () 117
()
+
()
0 ()
115
()

24
()
+ ()
.
23
()

7. Conclusion
(39)

By simplifying this expression in terms of the models of

0 ()/0 (), ()/(), and ()/(), and by recalling that
() = () () (), we can eventually write () as
() = [( () () ()) ()
+

117
() ( () + 1 1 + 2 2 2 )
115

24
() ( () + ( , ()) 2 )]
23

In this paper we consider asset portfolio and capital adequacy

management in banking. In particular, our objective is
to maximize an expected utility of a Basel III compliant
commercial banks asset portfolio at a future date > 0. From
the optimal investment strategy that solves our investment
problem we derive a dynamic formula for the Total Capital
Ratio or Capital Adequacy Ratio (CAR). In addition, we
derive a modified version of the banks asset portfolio that
would be obtained should the bank simultaneously follow
the optimal investment strategy and maintain its CAR at a
constant level of 8%. This modified portfolio is extremely
important since it takes maximum advantage by keeping
the Total Capital Ratio exactly at the threshold. This means
that all the funding available for investment is indeed being
invested.

10

Journal of Applied Mathematics

6

5.5
5
4.5
4
3.5
3
2.5
2
1.5
1

4
6
Time (years)

10

Modified asset portfolio

Figure 5: A simulation of (), the modified asset portfolio required

to maintain the Total Capital Ratio at 8%.

level of 8%. Of course, in line with Basel III standards, the

bank is able to absorb reasonable levels of unexpected losses
before becoming insolvent. Furthermore, in order to derive
the asset portfolio at constant (minimum) CAR value, the
level of bank capital needs to be controlled. This is done
modifying the deterministic capital model to be stochastic.
We find that the asset portfolio at constant (minimum) CAR
value grows considerably slower than the asset portfolio
of the original investment problem, but that this modified
portfolio is still maximal at the end of the investment period
under consideration. An interesting observation is that our
bank raises capital while at the same time lowering risk. A
possible explanation for this is that the bank holds low capital
Conservation Buffers, which it is trying to rebuild (see Heid
et al. [31]). In contrast, banks with large buffers maintain their
capital buffer by increasing risk when capital increases [31].
In future research it would be interesting to go beyond the
simulated data approach and model the CAR and bank asset
portfolio at constant (minimum) CAR value using real data
sourced from, for example, the US Federal Deposit Insurance
Corporation (FDIC).

Conflict of Interests
1.035

The authors declare that there is no conflict of interests

regarding the publication of this paper.

1.03
1.025

Acknowledgment

1.02

The authors acknowledge financial support from the National

Research Foundation of South Africa.

1.015
1.01

References

1.005
1
0.995

4
6
Time (years)

10

Controlled bank capital

Figure 6: A simulation of the bank capital, (), required to

maintain the Total Capital Ratio at 8%.

We present a simulation study in which we illustrate

the optimal investment strategy and characterize the corresponding CAR and modified asset portfolio. The main
results of our study are as follows. The optimal investment
strategy for the bank is to diversify its asset portfolio away
from the risky assets, that is, the security and loan and
towards the riskless treasury. This is in accordance with the
banking literature on optimal asset management in which
it is reported that banks diversify their asset portfolios in
an attempt to lower risk (see Dangl and Lehar [29] and
Decamps et al. [30] for instance). In doing so, the bank
maintains its CAR above the Basel III prescribed minimum

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