Loan Portfolio Risk and Capital Adequacy: A New Approach to Evaluating the Riskiness of Banks

65 Pages Posted: 28 Jun 2019 Last revised: 30 Aug 2019

See all articles by Charles M.C. Lee

Charles M.C. Lee

Stanford University - Graduate School of Business

Yanruo Wang

Nipun Capital

Qinlin Zhong

Renmin University of China - School of Business

Date Written: August 28, 2019

Abstract

We develop a 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, even after controlling for all the CAMELS variables. Publicly-listed banks with higher ELPR have lower market implied costs-of-capital. ELPR also strongly predicts cross-sectional stock returns under stress conditions. During the financial crisis (7/2007-6/2011), a cash-neutral strategy that longs high-ELPR and shorts low-ELPR banks yields a monthly alpha of 3.3% to 4.2%. We conclude LPR captures key aspects of bank risk missed by a risk-weighted-asset approach.

Keywords: 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

Suggested Citation

Lee, Charles M.C. and Wang, Yanruo and Zhong, Qinlin, Loan Portfolio Risk and Capital Adequacy: A New Approach to Evaluating the Riskiness of Banks (August 28, 2019). Available at SSRN: https://ssrn.com/abstract=3410538 or http://dx.doi.org/10.2139/ssrn.3410538

Charles M.C. Lee (Contact Author)

Stanford University - Graduate School of Business ( email )

Stanford Graduate School of Business
655 Knight Way
Stanford, CA 94305-5015
United States
650-721-1295 (Phone)

Yanruo Wang

Nipun Capital ( email )

Foster City, CA

Qinlin Zhong

Renmin University of China - School of Business ( email )

Beijing
China

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