Capital ratios as predictors of bank failure
The current review of the 1988 Basel Capital Accord has put the spotlight on the ratios used to assess banks? capital adequacy. This article examines the effectiveness of three capital ratios?the first based on leverage, the second on gross revenues, and the third on risk-weighted assets?in forecasting bank failure over different time frames. Using 1988-93 data on U.S. banks, the authors find that the simple leverage and gross revenue ratios perform as well as the more complex risk-weighted ratio over one- or two-year horizons. Although the risk-weighted measures prove more accurate in ...
Are bank shareholders enemies of regulators or a potential source of market discipline?
In moral hazard models, bank shareholders have incentives to transfer wealth from the deposit insurer--that is, maximize put option value--by pursuing riskier strategies. For safe banks with large charter value, however, the risk-taking incentive is outweighed by the possibility of losing charter value. Focusing on the relationship between book value, market value, and a risk measure, this paper develops a semi-parametric model for estimating the critical level of bank risk at which put option value starts to dominate charter value. From these estimates, we infer the extent to which the ...
Explanations for the increased riskiness of banks in the 1980s
The bank capital requirement and information asymmetry
This paper recognizes two main factors that cause the capital requirement to affect the weighted average cost of capital and hence the investment behavior of banks: underpriced debt resulting from the deposit insurance and information asymmetry between managers and the stock market. For a bank enjoying a low cost of debt (deposits), an increased proportion of equity financing raises the weighted average cost ofcapital. When the stock market underestimates the value of a bank due to information asymmetry, equity financing is expensive. This paper finds that banks constrained by the tightened ...
Option value of credit lines as an explanation of high credit card rates
Credit lines offered by credit cards contain an option arising from changing default probabilities of cardholders. The option value can explain high credit card rates and high profits of card issuers. The card rate producing zero profit for card issuers is higher than interest rates on most other loans because rational cardholders borrow more money when they become riskier. Furthermore, cardholders borrowing when the option is out of the money may be less responsive to credit cared rates due to higher switching costs and carelessness. Card issuers, therefore, keep card rates at high levels ...
Banking and deposit insurance as a risk-transfer mechanism
This paper models an economy in which risk-averse savers and risk-neutral entrepreneurs make investment decisions. Aggregate investment in high-yielding risky projects is maximized when risk-neutral agents bear all nondiversifiable risks. A role of banks is to assume nondiversifiable risks by pledging their capital in addition to diversifying risks. Banks, however, do not completely eliminate risks when monitoring by depositors is not perfect. Government deposit insurance that uses tax revenue to pay off depositors effectively remaining risks to entrepreneurs. Deposit insurance improves ...
The relationship between government financial condition and expected tax rates reflected in municipal bond yields
Yields on long-term municipal bonds reflect both current and expected future tax rates. This paper derives expected changes in tax rates from yields on short- and long-term municipal bonds and examines the relationship between expected changes in tax rates and the financial condition of the federal government between 1965 and 1994. The main empirical result is that a positive relationship exists between the expected tax rate and federal debt. Inflation also positively affects the expected tax rate, suggesting that investors may expect tight fiscal policies when inflation is high. Qualitative ...