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
Date Written: August 28, 2019
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
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