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

Abstract

We develop an accounting-based Loan Portfolio Risk (LPR) variable that measures time-varying volatility in default risk for a portfolio of bank loans. An Equity-to-LPR ratio (ELPR) is incrementally important in predicting bank failure up to five years in advance, after controlling for all the CAMELS variables. It is also additive to other fundamental-based risk measures from prior studies. Further, we find publicly-listed banks with higher ELPR have lower market-implied costs-of-capital, and ELPR strongly predicts cross-sectional stock returns under market stress conditions after adjusting for other known risk factors. We conclude 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