Bank Valuation and Its Connections with the Subprime Mortgage Crisis and Basel II Capital Accord

The ongoing subprime mortgage crisis (SMC) and implementation of Basel IICapital Accord regulation have resulted in issues related to bankvaluation and profitability becoming more topical. Profit is a majorindicator of financial crises for households, companies, and financial institutions. An SMC-related example of this is the U.S. bank,Wachovia Corp., which reported major losses in the first quarter of 2007and eventually was bought by Citigroup in September 2008. A firstobjective of this paper is to value a bank subject to Basel II basedon premiums for market, credit, and operational risk. In this case, weinvestigate the discrete-time dynamics of banking assets, capital, andprofit when loan losses and macroeconomic conditions are explicitlyconsidered. These models enable us to formulate an optimal bankvaluation problem subject to cash flow, loan demand, financing, andbalance sheet constraints. The main achievement of this paper is bankvalue maximization via optimal choices of loan rate and supply whichleads to maximal deposits, provisions for deposit withdrawals, and bankprofitability. The aforementioned loan rates and capital provideconnections with the SMC. Finally, OECD data confirms that loan lossprovisioning and profitability are strongly correlated with thebusiness cycle