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Loan Portfolio Risk and Capital Adequacy: A New Approach to Evaluating the Riskiness of Banks
|Title:||Loan Portfolio Risk and Capital Adequacy: A New Approach to Evaluating the Riskiness of Banks|
|Authors:||Charles M C Lee|
|Keywords:||bank failure prediction|
financial statement analysis
riskiness of banks
show 3 morecapital adequacy
loan default contagion
|Date Issued:||28 Aug 2019|
|Abstract:||We develop a Loan Portfolio Risk (LPR) variable that measures time-varying volatility in default risk for a portfolio of bank loans. An Equity-to-LPR ratio (ELPR) is incrementally important in predicting bank failure up to five years in advance, even after controlling for all the CAMELS variables. Publicly-listed banks with higher ELPR have lower market implied costs-of-capital. ELPR also strongly predicts cross-sectional stock returns under stress conditions. During the financial crisis (7/2007-6/2011), a cash-neutral strategy that longs high-ELPR and shorts low-ELPR banks yields a monthly alpha of 3.3% to 4.2%. We conclude LPR captures key aspects of bank risk missed by a risk-weighted-asset approach.|
|Appears in Collections:||
09 Financial: Fair Value Accounting/Intangible Assets/Innovations|
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