Journal of Risk Model Validation

Risk.net

Banks’ expected equity-to-asset ratio bounds under foreign exchange risk

Martín Egozcue and Luis Fuentes García

  • Expected equity ratio bounds of a bank that receives exchange rate shocks are presented.
  • These optimal bounds are easy to calculate since they only require accounting data and limited information about the exchange rate distribution.
  • The bounds can help regulators and practitioners to assess the financial strength of financial institutions.

ABSTRACT

In this paper, we develop optimal bounds of the expectation equity-to-asset ratio when the bank faces foreign exchange shocks. These bounds can be established with limited information on the underlying stochastic foreign exchange rate. Specifically, we are interested in finding the highest lower bound on the expectation of this ratio, as it indicates the worst case scenario of a bank's net worth. Comparative statics of these bounds, when the moments of the foreign exchange rate distribution vary, are studied as well. We characterize the conditions under which the expected equity ratio remains unchanged by foreign exchange rate movements. We also establish the optimal bounds of this expected ratio when the foreign exchange rate behaves as a mixture distribution. To our knowledge, the bounds of the type developed here have not previously been proposed in the banking literature.

 

 

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