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

HOW SHOULD WE MEASURE BANK CAPITAL ADEQUACY?A (SIMPLE) PROPOSAL

ByLucy Chernykh

Clemson University

Rebel A. ColeDePaul University

2014 Annual Meetings of the Financial Management Association

Nashville, TN USAOct. 18, 2014

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

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NPA ($000) LLR ($000)

Coverage ratio (LLR/NPA, %)


Banks with worst Nonperforming Asset Coverage Ratios (NPACR)

As of Year-End 2009Obs

FDIC Cert. Bank Name City ST NPACR NPA TE_TA LLR REO NonAccr PD90 PD30

1 5672 FLORIDA CMNTY BK IMMOKALEE FL -0.310 0.398 0.002 0.065 0.104 0.268 0.001 0.0252 58429 WHEATLAND BK NAPERVILLE IL -0.305 0.393 -0.014 0.072 0.003 0.352 0.000 0.0373 21521 CITY BK LYNNWOOD WA -0.281 0.341 0.032 0.010 0.151 0.167 0.000 0.0234 57147 PREMIER AMER BK MIAMI FL -0.280 0.388 0.000 0.045 0.018 0.292 0.000 0.0775 57448 FIRST CMRC CMNTY BK DOUGLASVILLE GA -0.280 0.384 0.059 0.016 0.146 0.202 0.000 0.0366 29952 GEORGE WA SVG BK ORLAND PARK IL -0.277 0.450 0.033 0.052 0.045 0.296 0.000 0.1107 57399 MCINTOSH CMRL BK CARROLLTON GA -0.268 0.363 0.023 0.013 0.132 0.143 0.039 0.0508 35279 HIGH DESERT ST BK ALBUQUERQUE NM -0.259 0.346 0.035 0.041 0.112 0.220 0.000 0.0149 58072 USA BK PORTCHESTER NY -0.245 0.297 0.030 0.018 0.009 0.282 0.000 0.006

10 59021 INDEPENDENT BKR BK SPRINGFIELD IL -0.234 0.000 -0.234 0.000 0.000 0.000 0.000 0.00011 58104 CENTURY SCTY BK DULUTH GA -0.219 0.304 0.024 0.011 0.174 0.061 0.012 0.05712 33904 GORDON BK GORDON GA -0.210 0.332 0.064 0.029 0.112 0.184 0.000 0.03613 1252 BARNES BKG CO KAYSVILLE UT -0.197 0.299 0.009 0.081 0.083 0.201 0.000 0.01514 57697 TOWNE BK OF AZ MESA AZ -0.194 0.313 0.056 0.034 0.195 0.081 0.000 0.03715 5702 COMMUNITY B&TC CORNELIA GA -0.193 0.296 0.016 0.030 0.036 0.188 0.000 0.07216 33989 APPALACHIAN CMNTY BK ELLIJAY GA -0.192 0.269 0.018 0.023 0.129 0.094 0.004 0.04317 34658 CITIZENS B&TC CHICAGO IL -0.190 0.340 0.031 0.024 0.033 0.160 0.074 0.07318 34613 BUILDERS BK CHICAGO IL -0.189 0.265 0.062 0.014 0.106 0.160 0.000 0.00019 35299 SECURITY EXCH BK MARIETTA GA -0.187 0.312 0.054 0.025 0.124 0.120 0.028 0.03920 19252 FIRST ST BK STOCKBRIDGE GA -0.186 0.286 0.038 0.021 0.077 0.157 0.001 0.051


ObsFDIC Cert. Bank Name City ST NPACR NPA E_TA LLR REO NonAccr PD90 PD30

1 34613 BUILDERS BK CHICAGO IL -0.293 0.397 0.075 0.013 0.178 0.200 0.000 0.0192 21649 DOUGLAS CTY BK DOUGLASVILLE GA -0.274 0.360 0.047 0.009 0.178 0.144 0.000 0.0383 19252 FIRST ST BK STOCKBRIDGE GA -0.260 0.350 0.027 0.019 0.140 0.154 0.002 0.0534 34292 BANK COMMERCE WOOD DALE IL -0.257 0.348 0.004 0.049 0.077 0.224 0.000 0.0475 35299 SECURITY EXCH BK MARIETTA GA -0.255 0.333 0.036 0.017 0.254 0.048 0.000 0.0316 19554 HIGH TRUST BK STOCKBRIDGE GA -0.248 0.372 0.033 0.025 0.119 0.168 0.009 0.0767 19758 ENTERPRISE BKG CO MCDONOUGH GA -0.248 0.305 0.013 0.015 0.056 0.212 0.000 0.0388 35242 NORTH GA BK WATKINSVILLE GA -0.245 0.287 0.004 0.007 0.080 0.161 0.017 0.0299 57440 OGLETHORPE BK BRUNSWICK GA -0.244 0.289 -0.027 0.021 0.072 0.142 0.033 0.042

10 58273 PATRIOT BK OF GA CUMMING GA -0.241 0.318 0.023 0.018 0.133 0.137 0.009 0.03911 58539 FIRST CHOICE CMNTY BK DALLAS GA -0.224 0.274 -0.025 0.051 0.010 0.234 0.004 0.02612 57646 FIRSTIER BK LOUISVILLE CO -0.220 0.274 -0.003 0.046 0.081 0.179 0.000 0.01413 57432 AMERICAN TR BK ROSWELL GA -0.212 0.261 0.006 0.013 0.084 0.133 0.018 0.02514 151 HABERSHAM BK CLARKESVILLE GA -0.212 0.261 0.007 0.017 0.105 0.123 0.004 0.02915 4744 FIRST NB OF OLATHE OLATHE KS -0.208 0.299 0.029 0.041 0.126 0.146 0.002 0.02416 57256 PIEDMONT CMNTY BK GRAY GA -0.203 0.288 0.043 0.024 0.135 0.130 0.000 0.02317 25155 FIRST NB OF FL MILTON FL -0.195 0.295 0.067 0.030 0.099 0.194 0.000 0.00318 19498 MONTGOMERY B&TC AILEY GA -0.192 0.304 0.073 0.014 0.114 0.159 0.000 0.03219 19237 MCINTOSH ST BK JACKSON GA -0.189 0.246 0.022 0.028 0.075 0.160 0.005 0.00720 34965 FIRST CMRL BK OF FL ORLANDO FL -0.188 0.236 -0.023 0.063 0.026 0.200 0.000 0.009

Banks with worst Nonperforming Asset Coverage Ratios (NPACR)

As of Year-End 2010


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.


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.


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

http://www.chicagofed.org/

Definitions of Capital Ratios

Capital ratio Notation Definition Regulatory capital ratios: Leverage ratio E/TA Book equity capital divided by year-end assets Tangible equity ratio

TE/TAA Tangible equity a divided by average total assets

Tier 1 risk-based capital ratio

T1/RWA The Tier 1b capital divided by risk-weighted d assets.

Total risk-based capital ratio

TOT/RWA The sum of Tier 1 and Tier 2 c capital divided by risk-weighted assets.

Proposed ratio: Nonperforming assets coverage ratio

NPACR Book equity capital plus loan loss reserves less nonperforming assets, all divided by year-end assets:

NPACR = (E + LLR – NPA) / TA, where the nonperforming assets are calculated as the sum of 20% of loans past due 30-89 days, 50% of loans past due 90-180 days, and 100% of nonaccrual loans and OREO

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

http://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

PCA capital categories:

Total

risk-based

capital ratio

Tier1

risk-based

capital ratio

Tier1

leverage

ratio

Well capitalized ≥ 10% and ≥ 6% and ≥ 5%

Adequately capitalized ≥ 8% and ≥ 4% and ≥ 4%a

Undercapitalized < 8% or < 4% or < 4%a

Significantly

undercapitalized < 6% or < 3% or < 3%

Critically

undercapitalized Tangible Equity ratio < 2%

Data

Number of banks

2007 2008 2009 2010All

years

All banks 7,603 7,439 7,211 6,895 29,148

including:

Well-Capitalized 7,526 7,255 6,873 6,587 28,241

Adequately Capitalized 71 131 167 137 506

Undercapitalized 3 29 83 75 190

Critically Undercapitalized 3 15 52 63 133

Significantly Undercapitalized 0 9 36 33 78

Data

Number of banks

2007 2008 2009 2010 All yearsFailed over a two-year window 150 264 225 128 767

including:

Well-Capitalized 143 174 52 17 386

Adequately Capitalized 4 51 43 16 114

Undercapitalized 1 20 57 26 104

Critically Undercapitalized 2 12 41 39 94Significantly Undercapitalized 0 7 32 30 69

Data

Ratio Well-Capitalized

Failed Survived Diff.

E/TA 0.094 0.113 -0.019***

TE/TAA 0.089 0.108 -0.019***

T1/RWA 0.110 0.161 -0.051***

TOT/RWA 0.123 0.173 -0.049***

NPACR 0.044 0.105 -0.061***

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.


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.


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.


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

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