The Predictive Power of Capital Adequacy Ratios on Bank Risk

Abstract

Risk management is a main issue on accounting research recently. This study investigates whether capital adequacy ratios (Basel regulatory capital ratio under 1998 version and traditional capital ratio on the balance sheet) can predict subsequent bank risk, and whether the regulatory risk-based capital ratio is more useful as a warning indicator for bank solvency than the traditional capital ratio in Taiwan. Considering characteristics of banking industry, this study employs an option pricing methodology to obtain implied asset risk as a market-based proxy for a bank's total risk. Empirical results indicate that both capital ratios are negatively associated with subsequent bank risk, and that the regulatory risk-based capital ratio more completely predicts bank risk than the traditional capital ratio does. In other words, the urging warning function of the risk-based capital requirement on bank risk is effective.