A Comprehensive Approach to the Capital Requirements Based on EVA

Abstract

We propose a holistic approach to balance sheet management to show how banks can meet both regulatory capital (proposed under Basel III) and shareholders’ wealth simultaneously. Using the consolidated balance sheet, this work outlines a methodology for mapping between targeted credit risks based capital ratio and economic value added by which banks can predict their optimal balance sheet. The results of this study are as follows. First, using an ex-ante approach, we predict the optimized balance sheet in each year from the previous year's data. By imposing the restriction of a maximum of 5% possible changes in the balance sheet items compared to the real changes, we could make an optimized balance sheet in which we predict more EVA with the same capital ratio compared to the real performance in each year. Second, in the ex-post approach, we use the optimized balance sheet items predicted by the ex-ante approach and assume that if this optimized balance sheet is used by the bank in practice, how much more EVA will be gained. The results show that in this approach (the ex-post approach), we could generate more EVA. It means that if the bank had used this optimized balance sheet in practice, it could have made more EVA. Robustness tests also support our main results when we impose more restrictions on the analysis.