Capital Ratios as Predictors of Bank Failure

Abstract

The current review of the 1988 Basel Capital Accord has put the spotlight on the ratios used to assess banks' capital adequacy. This article examines the effectiveness of three capital ratios - the first based on leverage, the second on gross revenues, and the third on risk-weighted assets - in forecasting bank failure over different time frames. Using 1988-93 data on U.S. banks, the authors find that the simple leverage and gross revenue ratios perform as well as the more complex risk-weighted ratio over one- or two-year horizons. Although the risk-weighted measures prove more accurate in predicting bank failure over longer horizons, the simple ratios are less costly to implement and could function as useful supplementary indicators of capital adequacy.

Keywords: bank regulation, capital requirements, Basel Accord, bank failures

JEL Classification: G21, G28