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
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 nonperforming 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 nonperforming assets.
Forbearance in the
U.S. Banking System 2007 - 2012
400,000,000
160%
350,000,000
140%
300,000,000
120%
250,000,000
100%
200,000,000
80%
150,000,000
60%
100,000,000
40%
50,000,000
20%
NPA ($000)
LLR ($000)
Coverage ratio (LLR/NPA, %)
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
0%
1992
0
Forbearance in the
U.S. Banking System 2007 - 2012
Banks with worst Nonperforming Asset Coverage Ratios (NPACR)
As of Year-End 2009
FDIC
Obs Cert.
Bank Name
1
5672 FLORIDA CMNTY BK
2
58429 WHEATLAND BK
3
21521 CITY BK
4
57147 PREMIER AMER BK
5
57448 FIRST CMRC CMNTY BK
6
29952 GEORGE WA SVG BK
7
57399 MCINTOSH CMRL BK
8
35279 HIGH DESERT ST BK
9
58072 USA BK
10
59021 INDEPENDENT BKR BK
11
58104 CENTURY SCTY BK
12
33904 GORDON BK
13
1252 BARNES BKG CO
14
57697 TOWNE BK OF AZ
15
5702 COMMUNITY B&TC
16
33989 APPALACHIAN CMNTY BK
17
34658 CITIZENS B&TC
18
34613 BUILDERS BK
19
35299 SECURITY EXCH BK
20
19252 FIRST ST BK
City
IMMOKALEE
NAPERVILLE
LYNNWOOD
MIAMI
DOUGLASVILLE
ORLAND PARK
CARROLLTON
ALBUQUERQUE
PORTCHESTER
SPRINGFIELD
DULUTH
GORDON
KAYSVILLE
MESA
CORNELIA
ELLIJAY
CHICAGO
CHICAGO
MARIETTA
STOCKBRIDGE
ST NPACR NPA TE_TA LLR REO NonAccr PD90 PD30
FL
-0.310 0.398
0.002 0.065 0.104
0.268 0.001 0.025
IL
-0.305 0.393
-0.014 0.072 0.003
0.352 0.000 0.037
WA
-0.281 0.341
0.032 0.010 0.151
0.167 0.000 0.023
FL
-0.280 0.388
0.000 0.045 0.018
0.292 0.000 0.077
GA
-0.280 0.384
0.059 0.016 0.146
0.202 0.000 0.036
IL
-0.277 0.450
0.033 0.052 0.045
0.296 0.000 0.110
GA
-0.268 0.363
0.023 0.013 0.132
0.143 0.039 0.050
NM
-0.259 0.346
0.035 0.041 0.112
0.220 0.000 0.014
NY
-0.245 0.297
0.030 0.018 0.009
0.282 0.000 0.006
IL
-0.234 0.000
-0.234 0.000 0.000
0.000 0.000 0.000
GA
-0.219 0.304
0.024 0.011 0.174
0.061 0.012 0.057
GA
-0.210 0.332
0.064 0.029 0.112
0.184 0.000 0.036
UT
-0.197 0.299
0.009 0.081 0.083
0.201 0.000 0.015
AZ
-0.194 0.313
0.056 0.034 0.195
0.081 0.000 0.037
GA
-0.193 0.296
0.016 0.030 0.036
0.188 0.000 0.072
GA
-0.192 0.269
0.018 0.023 0.129
0.094 0.004 0.043
IL
-0.190 0.340
0.031 0.024 0.033
0.160 0.074 0.073
IL
-0.189 0.265
0.062 0.014 0.106
0.160 0.000 0.000
GA
-0.187 0.312
0.054 0.025 0.124
0.120 0.028 0.039
GA
-0.186 0.286
0.038 0.021 0.077
0.157 0.001 0.051
Forbearance in the
U.S. Banking System 2007 - 2012
Banks with worst Nonperforming Asset Coverage Ratios (NPACR)
As of Year-End 2010
FDIC
Obs Cert. Bank Name
1 34613 BUILDERS BK
2 21649 DOUGLAS CTY BK
3 19252 FIRST ST BK
4 34292 BANK COMMERCE
5 35299 SECURITY EXCH BK
6 19554 HIGH TRUST BK
7 19758 ENTERPRISE BKG CO
8 35242 NORTH GA BK
9 57440 OGLETHORPE BK
10 58273 PATRIOT BK OF GA
11 58539 FIRST CHOICE CMNTY BK
12 57646 FIRSTIER BK
13 57432 AMERICAN TR BK
14
151 HABERSHAM BK
15 4744 FIRST NB OF OLATHE
16 57256 PIEDMONT CMNTY BK
17 25155 FIRST NB OF FL
18 19498 MONTGOMERY B&TC
19 19237 MCINTOSH ST BK
20 34965 FIRST CMRL BK OF FL
City
CHICAGO
DOUGLASVILLE
STOCKBRIDGE
WOOD DALE
MARIETTA
STOCKBRIDGE
MCDONOUGH
WATKINSVILLE
BRUNSWICK
CUMMING
DALLAS
LOUISVILLE
ROSWELL
CLARKESVILLE
OLATHE
GRAY
MILTON
AILEY
JACKSON
ORLANDO
ST NPACR NPA E_TA LLR REO NonAccr PD90 PD30
IL
-0.293 0.397 0.075 0.013 0.178
0.200 0.000 0.019
GA
-0.274 0.360 0.047 0.009 0.178
0.144 0.000 0.038
GA
-0.260 0.350 0.027 0.019 0.140
0.154 0.002 0.053
IL
-0.257 0.348 0.004 0.049 0.077
0.224 0.000 0.047
GA
-0.255 0.333 0.036 0.017 0.254
0.048 0.000 0.031
GA
-0.248 0.372 0.033 0.025 0.119
0.168 0.009 0.076
GA
-0.248 0.305 0.013 0.015 0.056
0.212 0.000 0.038
GA
-0.245 0.287 0.004 0.007 0.080
0.161 0.017 0.029
GA
-0.244 0.289 -0.027 0.021 0.072
0.142 0.033 0.042
GA
-0.241 0.318 0.023 0.018 0.133
0.137 0.009 0.039
GA
-0.224 0.274 -0.025 0.051 0.010
0.234 0.004 0.026
CO
-0.220 0.274 -0.003 0.046 0.081
0.179 0.000 0.014
GA
-0.212 0.261 0.006 0.013 0.084
0.133 0.018 0.025
GA
-0.212 0.261 0.007 0.017 0.105
0.123 0.004 0.029
KS
-0.208 0.299 0.029 0.041 0.126
0.146 0.002 0.024
GA
-0.203 0.288 0.043 0.024 0.135
0.130 0.000 0.023
FL
-0.195 0.295 0.067 0.030 0.099
0.194 0.000 0.003
GA
-0.192 0.304 0.073 0.014 0.114
0.159 0.000 0.032
GA
-0.189 0.246 0.022 0.028 0.075
0.160 0.005 0.007
FL
-0.188 0.236 -0.023 0.063 0.026
0.200 0.000 0.009
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
Capital ratio
Notation
Regulatory capital ratios:
Leverage ratio
E/TA
Tangible equity
TE/TAA
ratio
Tier 1 risk-based
T1/RWA
capital ratio
Total risk-based
TOT/RWA
capital ratio
Proposed ratio:
Nonperforming
assets coverage
ratio
NPACR
Definition
Book equity capital divided by year-end assets
Tangible equity a divided by average total assets
The Tier 1b capital divided by risk-weighted d assets.
The sum of Tier 1 and Tier 2 c capital divided by riskweighted assets.
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
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 twoyear 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
Tier1
Tier1
risk-based
risk-based
leverage
capital ratio
capital ratio
ratio
≥ 10%
and
≥ 6%
and
≥ 5%
Adequately capitalized
≥ 8%
and
≥ 4%
and
≥ 4%a
Undercapitalized
< 8%
or
< 4%
or
< 4%a
< 6%
or
< 3%
or
< 3%
Well capitalized
Significantly
undercapitalized
Critically
Data
Number of banks
2007
2008
All
2009 2010 years
All banks
including:
7,603
7,439 7,211 6,895 29,148
Well-Capitalized
Adequately Capitalized
Undercapitalized
Critically Undercapitalized
Significantly Undercapitalized
7,526
71
3
3
0
7,255 6,873 6,587 28,241
131 167 137
506
29
83 75
190
15
52 63
133
9
36 33
78
Data
Number of banks
2007
Failed over a two-year
window
2008 2009 2010 All years
150
264 225
128
767
143
174
52
17
386
Adequately Capitalized
4
51
43
16
114
Undercapitalized
1
20
57
26
104
Critically Undercapitalized
2
12
41
39
94
Significantly Undercapitalized
0
7
32
30
69
including:
Well-Capitalized
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 outcomes
well-capitalized banks
2007 Data: 2008-2009 outcomes: 143 failures and 7,383 survivals
Two-year window survival outcomes
well-capitalized banks
2008 Data: 2009-2010 outcomes: 174 failures and 7,081 survivals
Two-year window survival outcomes
well-capitalized banks
2009 Data: 2010-2011 outcomes: 52 failures and 6,821 survivals)
Two-year window survival outcomes
well-capitalized banks
2010 Data: 2011-2012 outcomes: 17 failures and 6,570 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 crosscountry 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