How should we measure bank capital adequacy for triggering Prompt Corrective Action? A (simple) proposal

Abstract

In this study, we test the predictive power of several alternative measures of bank capital adequacy in identifying U.S. bank failures during the recent crisis period. We find that an unconventional ratio – the non-performing asset coverage ratio (NPACR) – significantly outperforms Basel-based ratios including the Tier 1 ratio, the Total Capital Ratio, and the Leverage ratio – throughout the crisis period. It also outperforms in predicting failures among “well-capitalized” banks (as defined by the current Prompt Corrective Action guidelines). Based on our results, we argue that NPACR outperforms other ratios in at least five aspects: (i) it aligns capital and credit risks – the two primary risks of bank failures – in one measure; (ii) it is easier to calculate than the Tier 1 and Total Capital ratios, as it requires calculation of no complex risk weights; (iii) it allows one to account for various time period and cross-country provisioning rules and regimes, including episodes of regulatory forbearance and cross-country differences; (iv) it removes the incentives of both banks and regulators to mask capital deficiencies by creating/requiring insufficient loan-loss reserves; and (v) it outperforms all other commonly used capital ratios in predicting bank failures. We believe that all the above features of proposed measure promise its effective use in the prompt corrective actions by bank regulators. We also expect that this single and informative measure of bank risk can be efficiently used in empirical banking studies. The results of this study also shed light on regulatory forbearance during the recent banking crisis.