ELPR: A New Approach to Measuring the Capital Adequacy of Commercial Banks

Abstract

We develop and evaluate an accounting-based Loan Portfolio Risk (LPR) variable that captures time-varying contagion effects in default risk for a portfolio of bank loans. Our results show that an Equity-to-LPR ratio (ELPR) is additive in predicting bank failure up to five years in advance, after controlling for all the CAMELS variables as well as other fundamental-based bank risk measures from prior studies. Further, we find that publicly listed banks with higher ELPR have lower market-implied costs of capital, especially under market stress conditions. We conclude that ELPR captures key aspects of bank risk that are missing in current Basel Committee risk-weighted-asset calculations.

Keywords: bank regulation, bank failure prediction, financial statement analysis, risk-weighted assets, riskiness of banks, financial crisis, capital adequacy, loan default contagion, market efficiency

JEL Classification: E32, G14, G21, K23, M41, M48