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Strategic risk, banks, and Basel III: estimating economic capital requirements

Author

Listed:
  • Arun Chockalingam
  • Shaunak Dabadghao
  • Rene Soetekouw

Abstract

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.

Suggested Citation

  • Arun Chockalingam & Shaunak Dabadghao & Rene Soetekouw, 2018. "Strategic risk, banks, and Basel III: estimating economic capital requirements," Journal of Risk Finance, Emerald Group Publishing Limited, vol. 19(3), pages 225-246, July.
  • Handle: RePEc:eme:jrfpps:jrf-11-2016-0142
    DOI: 10.1108/JRF-11-2016-0142
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    Citations

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    Cited by:

    1. Shailesh Rastogi & Rajani Gupte & R. Meenakshi, 2021. "A Holistic Perspective on Bank Performance Using Regulation, Profitability, and Risk-Taking with a View on Ownership Concentration," JRFM, MDPI, vol. 14(3), pages 1-22, March.
    2. Tomer Kedarya & Amir Elalouf & Rafael Sherbu Cohen, 2023. "Calculating Strategic Risk in Financial Institutions," Global Journal of Flexible Systems Management, Springer;Global Institute of Flexible Systems Management, vol. 24(3), pages 361-372, September.
    3. Irena Pyka & Aleksandra Nocoń, 2021. "Bank Risk Capital and Its Effectiveness in Selected Euro Area Banking Sectors," JRFM, MDPI, vol. 14(11), pages 1-18, November.
    4. Salami Abdulai Agbaje & Uthman Ahmad Bukola & Sanni Mubaraq, 2021. "Bank-Specific Variables and Banks’ Financial Soundness: Empirical Evidence from Nigeria," Zagreb International Review of Economics and Business, Sciendo, vol. 24(1), pages 37-66.
    5. Kofi Twum Antwi & Beatrice Darko Obiri & Elizabeth Asantewaa Obeng & Simon Abugre, 2020. "Assessment of Environmental Sources of Financial Risks on Commercial Banks in Ghana," International Journal of Finance & Banking Studies, Center for the Strategic Studies in Business and Finance, vol. 9(3), pages 86-98, July.

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