Strategic Risk, Banks, and Basel III: Estimating Economic Capital Requirements

Purpose Basel III regulations require banks to protect themselves against strategic risk. This paper aims to provide a comprehensive and measurable definition of this risk and proposes a framework to estimate economic capital requirements. Design/methodology/approach The paper studies the literature and solicits expert opinion in formulating a comprehensive and measurable definition of strategic risk. The paper postulates that the economic capital for a bank’s strategic risk should be estimated using the cost of equity as the profitability threshold, rather than zero and develops a simulation-based framework to estimate economic capital. Findings The framework closely matches the actual economic capital outlay for strategic risk from our case study of ABN AMRO. It is shown that a bank’s strategic growth plans can fall into one of two scenarios based on risk-return characteristics. In one scenario, the required economic capital outlay will increase, and decrease in the other. Practical implications This framework is generalizable and makes use of widely accepted and used practices in banks, making it readily implementable in practice. It does not introduce errors resulting from model selection, parameterizations or complex calculations. Social implications Society would be worse off in the absence of banking and lending services. Banks need to take risks to grow and stay competitive. The framework facilitates better strategic risk management, protecting banks from collapse and reducing the need for taxpayer-funded bailouts. Originality/value The paper provides a measurable and practitioner-verified definition of strategic risk and proposes a simple framework to estimate economic capital requirements, a crucial topic, given the threats and increased levels of strategic risk facing banks.