Abstract
In this paper, we examine the use of book-to-market equity (BE/ME) as a determinant of asset correlations in the Basel Accord on regulatory capital requirements. Utilizing an international sample from 38 countries during 1989–2017, we discover that asset correlations, controlling for firm size and default probability, are negatively associated with BE/ME. We further decompose BE/ME according to Daniel and Titman (2006) and Penman et al. (2007) to explore why BE/ME can capture variations in asset correlations. The former method demonstrates that obligors with higher assets-in-place (higher BE/ME) exhibit lower asset correlations, and the latter approach reveals that obligors with higher operating risk have lower asset correlations. These findings suggest that BE/ME is potentially a crucial factor in improving estimates of asset correlations and reducing bank regulatory capital arbitrage.
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