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 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

Banks with worst Nonperforming Asset Coverage Ratios (NPACR) As of Year-End 2009

Forbearance in the U.S. Banking System Banks with worst Nonperforming Asset Coverage Ratios (NPACR) As of Year-End 2010

Forbearance in the U.S. Banking System  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 59 th 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  2010: Douglas City Bank is 2 nd 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 24 th 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 86 th 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  2010: 4 th 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 59 th worst NPACR at -11.1% and nonperforming assets of 19.9%.  Two years earlier, Bank Commerce had the 232 nd 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

Definitions of Capital Ratios

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.

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 undercapitalizedTangible Equity ratio < 2%

Data Number of banks All years All banks7,6037,4397,2116,89529,148 including: Well-Capitalized7,5267,2556,8736,58728,241 Adequately Capitalized Undercapitalized Critically Undercapitalized Significantly Undercapitalized

Data Number of banks All years Failed over a two-year window including: Well-Capitalized Adequately Capitalized Undercapitalized Critically Undercapitalized Significantly Undercapitalized

Data RatioWell-Capitalized FailedSurvivedDiff. E/TA *** TE/TAA *** T1/RWA *** TOT/RWA *** NPACR ***

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: outcomes: 143 failures and 7,383 survivals

Two-year window survival outcomes well-capitalized banks 2008 Data: outcomes: 174 failures and 7,081 survivals

Two-year window survival outcomes well-capitalized banks 2009 Data: outcomes: 52 failures and 6,821 survivals)

Two-year window survival outcomes well-capitalized banks 2010 Data: 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 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.

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