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

57 Pages Posted: 28 Jun 2019 Last revised: 20 Oct 2020

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: October 19, 2020

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

Suggested Citation

Lee, Charles M.C. and Wang, Yanruo and Zhong, Qinlin, ELPR: A New Approach to Measuring the Capital Adequacy of Commercial Banks (October 19, 2020). 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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