Profitability and Capital Requirements for Banks Issuing Deposits

A simple analytical framework of bank’s behaviour is presented to explore the key drivers of banks’ profitability/valuation. A stochastic version of a simple Discount Cash Flow (DCF) model will be used to study/understand how low interest rates and prudential measures (here focus will be devoted on capital requirements) interact affecting bank’s profitability (focus here is on profits deriving from the “spread business” of traditional banking related to the rent implicit in their deposit/money creation). At this stage this is a partial equilibrium framework but many of the conclusions obtained can be easily generalized in a system-wide perspective (developed in a companion paper). Key research question: understand through a simple analytical framework how low interest rates and capital requirement endogenously affect valuation and consequently behaviour of a bank issuing deposits (and exploiting its implicit rent).