How should we measure bank capital adequacy? A (simple) proposal

By Lucy Chernykh Clemson University Rebel A. Cole DePaul University 2014 Annual Meetings of the Financial Management Association Nashville, TN USA Oct. 18, 2014 How should we measure bank capital adequacy?A (simple) proposal

Summary • We test the predictive power of alternative measures of bank capital adequacy in identifying U.S. bank failures during the recent crisis. • We find that an unconventional ratio—the non-performing asset coverage ratio (NPACR)—significantly outperforms Basel-based ratios, including the Tier 1, Total Capital, and Leverage ratios, throughout the crisis period. • It also outperforms in predicting failures among “well-capitalized” banks (as defined by the current Prompt Corrective Action guidelines).

Summary • We conclude that the NPACR is an attractive alternative to the Basel ratios for implementing prompt corrective actions. • Our results also shed light on regulatory forbearance during the recent banking crisis

Introduction • Amid the evolving Basel accords, regulators around the world have used increasingly complex measures of bank capital adequacy. • Haldane (2011) notes that, under Basel I, only a few calculations would produce a representative large bank’s regulatory capital ratio; • Under Basel II, closer to 200 million calculations are needed. • Basel III does little to change this situation.

Introduction • Haldane (2012) argues that “the type of complex regulation developed over recent decades might not just be costly and cumbersome but sub-optimal for crisis control.” • We follow Haldane’s advice by offering a very simple, timely, and robust measure of capital adequacy that we argue is superior to Basel regulatory capital ratios. • We support our claim with macro- and bank-level evidence from the U.S. banking system documenting early warning performance for our proposed capital adequacy measure that is superior to the Basel regulatory capital ratios.

Introduction • Our proposed capital adequacy ratio, which we call the Nonperforming Assets Coverage Ratio (NPACR), explicitly accounts for: • capital-constrained banks’ reluctance (or inability) to build up adequate reserves for anticipated future loan losses, and • regulators’ forbearance in enforcing loan-loss reserving requirements. • More specifically, our proposed simple formula for the NPACR ratio is as follows: total equity capital plus loan-loss reserves less nonperforming assets, all divided by total assets (all in book values).

Introduction • Each component of this formula is readily available from a representative bank’s regulatory filings. • The intuitive interpretation of the NPACR as a capital adequacy measure also is straightforward: • It is the ratio of equity to assets when every bank is forced to adequately provision against its non-performing assets.

Forbearance in the U.S. Banking System 2007 - 2012

Forbearance in the U.S. Banking System 2007 - 2012 Banks with worst Nonperforming Asset Coverage Ratios (NPACR) As of Year-End 2009

Forbearance in the U.S. Banking System 2007 - 2012 Banks with worst Nonperforming Asset Coverage Ratios (NPACR) As of Year-End 2010

Forbearance in the U.S. Banking System 2007 - 2012 • 2009: First State Bank of Stockbridge, GA shows up at number 20, with NPACR equal to -18.6%, nonperforming assets equal to 28.6% of assets, but loan-loss reserves of only 2.1% of assets and equity equal to 3.8% of assets. • Going back another full year to year-end 2008, First State Bank of Stockbridge shows up with the 59th worst NPACR at -4.8%; it also reports nonperforming assets equal to 20.6% of assets, but loan-loss reserves equal to only 1.2% of assets and equity equal to a relatively healthy 10.1% of assets.

Forbearance in the U.S. Banking System 2007 - 2012 • 2010: Douglas City Bank is 2nd on the list with a NPACR equal to -27.4% and nonperforming assets equal to 36.0% of assets, but loan-loss reserves of only 0.9% of assets and equity equal to 4.7% of assets. • As of year-end 2009, Douglas City bank had the 24th worst NPACR at -17.5% and nonperforming assets equal to 29.2% of assets, but loan-loss reserves of only 1.3% of assets and equity equal to 6.8% of assets. • Going back another full year, Douglas had the 86th worst NPACR at -2.5% and nonperforming assets equal to 16.5% of assets, but loan-loss reserves of only1.5% of assets and equity equal to 9.2% of assets.

Forbearance in the U.S. Banking System 2007 - 2012 • 2010: 4th on the list is Bank Commerce of Wood Dale, IL with an NPACR of ‑26.0% and nonperforming assets equal to 34.8% of assets. • A year earlier, Bank Commerce had the 59th worst NPACR at -11.1% and nonperforming assets of 19.9%. • Two years earlier, Bank Commerce had the 232nd worst NPACR at 1.7% and nonperforming assets equal to 8.8% of assets

Data • To construct various capital ratios for all U.S. commercial banks, we use the data from the Federal Financial Institutions Examination Council (FFIEC), which provides quarterly financial data for each FDIC-insured bank • More specifically, we obtain our data from the website of the Federal Reserve Bank of Chicago, which provides quarterly FFIEC data from 1980 through 2010. www.chicagofed.org

Definitions of Capital Ratios

Data • Our sample period covers 2007 to 2012, including banks’ year-end capital ratios for the 2007 to 2010 period and the corresponding two-year window survival outcomes for the 2009 to 2012 period. • Bank failure data come from the FDIC’s official list of closed banks. www.fdic.gov

Data • the total number of bank-year observations in our sample is 29,148, including: • 7,603 banks in 2007, • 7,439 banks in 2008, • 7,211 banks in 2009, and • 6,895 banks 2010

Data • The corresponding failure rates over the two-year window are: • 150 banks (or 1.97%) of banks that were active in 2007 but failed during 2008 – 2009; • 264 banks (or 3.55%) of banks that were active in 2008 but failed during 2009 – 2010; • 225 banks (or 3.12%) of banks that were active in 2009 but failed during 2010 – 2011, and • 128 banks (or 3.55%) of banks that were active in 2010 but failed during the 2011 – 2012

Data • We also report the distribution of capital adequacy for our sample banks based on the FDICIA Prompt Corrective Action (PCA) guidelines for the FDIC insured US banks. • .The standardized PCA capital-adequacy definitions rely on the • leverage ratio, • the Tier 1 risk-based capital ratio, • the total risk-based capital ratio, and • the tangible-equity ratio.

Data

Results: Receiver Operating Characteristic (ROC) Curves • ROC curves are similar to Type 1 vs. Type 2 error curves, except flipped 180 degrees vertically. • Vertical axis: • True Positives (Failures classified as Failures) • Horizontal axis: • False Positives (Survivals classified as Failures) • Perfect performance: vertical up, vertical across • Random: 45 degree line

Two-year window survival outcomeswell-capitalized banks 2007 Data: 2008-2009 outcomes: 143 failures and 7,383 survivals

Two-year window survival outcomeswell-capitalized banks 2009 Data: 2010-2011 outcomes: 52 failures and 6,821 survivals)

Summary and Conclusions • In this study, we test the predictive power of several alternative measures of bank capital adequacy in identifying U.S. bank failures during the recent crisis period. • We find that an unconventional ratio—the non-performing asset coverage ratio—outperforms Basel-based ratios including the Tier 1 ratio, the Total Capital Ratio, and the Leverage ratio—throughout the crisis period in identifying bank failures.

Summary and Conclusions • It also outperforms in predicting failures among “well-capitalized” banks as defined by the current Prompt Corrective Action guidelines. • From an early warning perspective, these banks are of most concern to regulators because they have not been identified as troubled by the PCA guidelines.

Summary and Conclusions • Based on our results, we argue that NPACR outperforms other ratios in at least five aspects: • (i) it aligns capital and credit risks—the two primary risks of bank failures—in one measure; • (ii) it is easier to calculate than the Tier 1 and Total Capital ratios, as it requires no complex calculations of risk weights; • (iii) it allows one to account for various time-period and cross-country provisioning rules and regimes, including episodes of regulatory forbearance and cross-country differences; • (iv) it removes the incentives of both banks and regulators to mask capital deficiencies by creating/requiring insufficient loan-loss reserves; and • (v) it outperforms all other commonly used capital ratios in predicting bank failures.

Summary and Conclusions • Our study makes three important contributions to the literature on financial institutions. • (i) we contribute to the literature on bank capital adequacy; • (ii) we contribute to the literature on regulatory forbearance and prompt corrective action • (iii) we contribute to the literature on bank failures

How should we measure bank capital adequacy? A (simple) proposal