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In a study of ratios designed to assess capital adequacy, authors Arturo Estrella, Sangkyun Park, and Stavros Peristiani find that even simple ratios can be informative and useful in predicting bank failures. The study comes as the Basel Committee on Banking Supervision is engaged in an effort to refine the 1988 Basel Accord.
Estrella, Park, and Peristiani examine the effectiveness of three capital ratios in forecasting bank failure over different time frames. The risk-weighted ratio--the most complex of the three--compares a banks capital with its risk-weighted assets, as defined in the Basel Accord.
The leverage ratio and the gross revenue ratio are simpler to compute: the first compares capital with total assets and the second with total interest and noninterest income. The authors ask whether each ratio is useful for bank regulation and whether it is significantly related to subsequent bank failure.
Their analysis shows that:
Simple leverage and gross revenue ratios perform as well as the more complex risk-weighted ratio in predicting bank failure over one- or two-year horizons.
Risk-weighted measures prove more accurate in forecasting failure over longer horizons.
Simple ratios are less costly to implement and could supplement more sohisticated measures by providing a timely signal of the need for supervisory action.
Bank regulators may find a useful role for the simple ratios in the design of regulatory capital frameworks, particularly as indicators of the need for prompt supervisory action.
Arturo Estrella is a senior vice president, Sangkyun Park an economist, and Stavros Peristiani a research officer at the Federal Reserve Bank of New York.