Capital Ratios and Credit Ratings as Predictors of Bank Failures

We examine the power of various capital ratios — scaled by total assets, riskweighted 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. ARTURO ESTRELLA is a senior vice president in the Capital Markets Function of the Federal Reserve Bank of New York. SANGKYUN PARK is an economist at the Office of Management and Budget. STAVROS PERISTIANI is a research officer in the Capital Markets Function of the Federal Reserve Bank of New York. *Corresponding author: Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045, phone 212-720-7829, e-mail [email protected]. Views expressed are those of the authors’ and do not necessarily reflect those of the Federal Reserve Bank of New York, the Federal Reserve System and the Office of Management and Budget. We thank Beverly Hirtle, Jim Mahohey, and participants in a workshop at the Federal Reserve Bank of New York for helpful comments and suggestions. We also thank Gijoon Hong for excellent research support.