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Capital Ratios as Predictors of Bank Failure

by Arturo Estrella of the Federal Reserve Bank of New York,
Sangkyun Park of the Federal Reserve Bank of New York, and
Stavros Peristiani of the Federal Reserve Bank of New York

July 2000

Abstract: We examine the power of various capital ratios -- scaled by total assets, risk-weighted assets and gross revenues -- to forecast U.S. bank failures. Capital ratios are the centerpiece of the 1988 Basel Accord, and various ratios are currently under consideration in Basel in connection with one of the three "pillars" of a more comprehensive approach to capital adequacy. Using data for the period 1988-1993, which included a relatively large number of failures, we conclude that all three ratios we examine are very significant predictors of failure, and that the simple ratios are about as strong as the more complex risk-weighted measure. Simpler ratios are less costly and may be more broadly applicable than risk-weighted ratios. We also compare the performance of credit ratings as predictors of failure, since credit ratings have a formal role in current regulation, and since the information they provide is correlated with that provided by capital ratios. The number of failed banks with ratings is very small, and evidence in favor of ratings is somewhat mixed.

Published in: FRBNY Economic Policy Review, Vol. 6, No. 2, (July 2000), pp. 33-52.

Previously titled: Capital Ratios and Credit Ratings as Predictors of Bank Failures

This paper is republished as Ch.11 in...

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