Capital and Risk in Commercial Banking: A Comparison of Capital and Risk-based Capital Ratios

Abstract

Recent changes in U.S. banking regulation have emphasized risk-based capital (RBC) as an indicator of bank soundness. This paper compares the RBC ratio to the standard capital ratio of equity over assets. We regress the capital and RBC ratios of bank holding companies from 1999 through 2010 against two measures of bank risk: the standard deviation of stock returns and the Z-score indicator of bank solvency. We find that the capital and RBC ratios are statistically significant predictors of both measures of risk. Comparing the capital and RBC ratios to each other, however, we find that the capital ratio is statistically significantly better than the RBC ratio as a predictor of risk, especially in the period since the recent financial crisis.

Keywords: Banks, Capital, Risk-based capital, Volatility, Regulation

JEL Classification: G21, G28, G32