CHAPTER 4Formulation of the Optimisation Process and Articulation of the Decision Model
Optimisation methods are used widely in engineering, physics, and medicine, and recently found their common application also in the banking industry.
The problem is now presented here in detail.
Put simply, a banking book of a bank is composed of a portfolio of assets with different repricing characteristics and different maturities (short-term and medium long-term assets). The liquidity portfolio is also part of the assets, which, according to Basel III requirements, has to act as a buffer in case of unexpected liquidity outflows. Its minimum amount is assessed through the liquidity stress test analysis.
The profitability of assets is always the result of the bank's willingness to take on a certain amount of risk, subject to constraints such as capital absorption and expected losses generated by this asset portfolio. Thus, the optimisation exercise here will consist of building the objective function which maximises asset profitability along with the appropriate constraint functions. The constraint functions will limit the exposure to the interest rate risk in terms of net interest income (NII) volatility and maturity transformation through keeping the liquidity ratio below the threshold level.
From the liability side, the purpose of the optimisation exercise consists of the determination of the funding structure that is cheapest for the bank. In this case, we will be looking for the values ...
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