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Capital Ratios as Predictors of Bank Failure

The sharp rise in crude oil prices that began in 1973 and continued for almost a decade accelerated this expansion in lending (see figure 5.1). In addition to generating inflationary pressures around the industrial world, these price movements caused serious balance of payments problems for developing nations by raising the cost of oil and of imported goods. Developing countries needed to finance these deficits, and many began to borrow large sums from banks on the international capital markets. 5 The oil price rise that caused the deficits also increased the quantity of funds available in the Eurodollar market through the dollar-denominated bank deposits of oil-exporting countries, thereby fueling. | Arturo Estrella Sangkyun Park and Stavros Peristiani Capital Ratios as Predictors of Bank Failure The current regulatory framework for determining bank capital adequacy is under review by the Basel Committee on Banking Supervision. An empirical analysis of the relationships between different capital ratios and bank failure suggests that two simple ratios the leverage ratio and the ratio of capital to gross revenue may merit a role in the revised framework. The leverage ratio and the gross revenue ratio predict bank failure about as well as more complex risk-weighted ratios over one- or two-year horizons. Risk-weighted ratios tend to perform better over longer horizons. The simple ratios are virtually costless to implement and could supplement more sophisticated measures by providing a timely signal of the need for supervisory action. Capital ratios have long been a valuable tool for assessing the safety and soundness of banks. The informal use of ratios by bank regulators and supervisors goes back well over a century Mitchell 1909 . In the United States minimum capital ratios have been required in banking regulation since 1981 and the Basel Accord has applied capital ratio requirements to banks internationally since 1988. The Basel Committee on Banking Supervision 1999 is currently engaged in an effort to improve the Basel Accord and once again capital ratios are being discussed as part of the proposed solution. In this article we examine some of the roles that capital ratios play in bank regulation and we argue that to be successful in any of these roles capital ratios should bear a significant negative relationship to the risk of subsequent bank failure. We then present empirical evidence of those relationships. We focus here on three types of capital ratios risk-weighted leverage and gross revenue ratios. For each ratio we examine what makes it actually or potentially useful for bank regulation and we ask whether it is indeed significantly related to subsequent