Regulatory capital decisions in the Context of consumer loan portfolios

Abstract

A topic of interest in recent literature is regulatory capital requirements for consumer loan portfolios. Banks are required to hold regulatory capital for unexpected losses, while expected losses are to be covered by either provisions or future income. In this paper, we show the set of efficient operating points in the market share and profit space for a portfolio manager operating under Basel II capital requirement and under capital constraints are a union of single-cutoff-score and double-cutoff-score operating points. For a portfolio manager to increase market-share beyond the maximum allowable under a single-cutoff score policy (eg, with binding capital constraints) requires granting loans to higher than optimal risk applicants. We show this result in greater portfolio risk but without an increase in regulatory capital requirement amount. The increase in forecasted losses is assumed to be absorbed by provisions or future margin income. Given portfolio managers take on higher risk under the same regulatory capital amount, our findings call for greater focus on provision amounts and future margin income under the supervisory review pillar of Basel II. This research raises the issue of whether the design of the regulatory formula for consumer loan portfolios is flawed.

Keywords:

• regulatory capital
• decision-making under risk
• Basel Accord

Acknowledgements

This work is based on the research supported in part by the National Research Foundation of South Africa for the Grant No. 46360 and No. 93649. Any opinion, finding, and conclusion or recommendation expressed in this material is that of the authors and the NRF does not accept any liability in this regard.

Notes

1 The capital requirement formulae did not change from Basel II to Basel III (see Huang and Thomas, 2015 for more).

2 This is similar to one of the cases in Thomas (2009), where all loans are funded through debt.