Stochastic Dynamic Optimization Models in the Banking Sector

by Rasmus Ahvenniemi

Institution: University of Helsinki
Department: Department of Economic and Political Studies, Taloustieteen oppiaine
Year: 2015
Keywords: taloustiede
Record ID: 1145419
Full text PDF: http://hdl.handle.net/10138/153099


The thesis consists of an introduction and 3 essays presenting stochastic dynamic optimization models concerning decision making in the banking sector. The first two essays consider individual banks in an environment where financial crises may occur. The third essay considers the whole banking sector as one entity which is a part of the economy, and thereby the process of money creation in the banking system becomes a central issue. The first essay presents a model for analyzing the optimal dynamic decision making of a bank, which adjusts the size and composition of its balance sheet over time. The model considers the development of the bank's balance sheet in a situation involving the risk of a financial crisis which may or may not materialize, and the timing of which is uncertain. The crisis may involve defaulting of loans and a reduction in the availability of funding. The maturing of loans and deposits taking place in each period is explicitly modeled, assuming maturity mismatch. The outcomes of the model show e.g. a tendency of the bank to deleverage its balance sheet in preparation for an anticipated financial crisis, as well as a tendency to accumulate cash reserves in order to maintain sufficient liquidity. The second essay presents a portfolio model for analyzing a bank making decisions over time in a stochastic environment. The bank is assumed to make decisions regarding the amount of new loans given out in each period, thus affecting the allocation of its funds between liquid cash and non-liquid loans. The model involves maturity mismatch and the risk of a liquidity crisis during which the availability of new funding is restricted. Simulations of the model show that a positive amount is allocated to cash even though cash pays zero returns and no credit risk or investment risk is present in the model, as long as maturity mismatch and the risk of a liquidity crisis are both present. The third essay presents a model of an economy consisting of a central bank, a commercial banking sector, and a real economy experiencing stochastic productivity shocks. A stochastic dynamic programming model is formulated for modeling the policy decisions of the central bank, which dynamically adjusts the size of the monetary base, attempting to keep inflation close to a target. It is assumed that reserve requirements may or may not be binding at a given time. When reserve requirements are not binding, money creation is endogenous, i.e. determined by lending decisions of commercial banks. These lending decisions are affected by the condition of the real economy and, to some extent, by central bank policies acting through transmission channels such as the portfolio rebalance effect. Lending stimulates the real economy while also accelerating inflation as it causes the money supply to grow. The outcomes show that during a recession lending by commercial banks is reduced, deflation prevails, and the central bank carries out expansionary monetary policy. When the recession ends, lending increases and there is a period of…