IMF published a working paper that measures the performance of different metrics in assessing banking system vulnerabilities. The study finds that metrics based on equity market valuations of bank capital are better than regulatory capital ratios and other metrics in spotting banks that failed. The paper proposes that these market-based ratios could be used as a surveillance tool to assess vulnerabilities in the banking sector.
The approach of the study presented in this paper was to test and calibrate different metrics using the banks that both failed and survived the global financial crisis. The out of sample performance of these metrics was then assessed using the banks that have since run into trouble (as well as those that have continued operating). The results show how the metrics can be implemented in practice and what they suggest about the risk of bank failures in the current environment. The paper has confirmed results of certain previous studies, which suggest that equity market-based capital ratios would have been better at signaling bank distress in the run-up to the global financial crisis than regulatory capital ratios—particularly the tier 1 capital ratio. In addition, the study tested the market-based capital ratios against other market and balance sheet indicators and found that the market-based capital ratios would have been better at predicting bank stress than these other metrics in the pre-crisis period. The analysis showed that the market-based capital ratios also performed well in the post-crisis period. This further supports the case for using these augmented capital ratios in assessing vulnerabilities in the banking sector.
The equity market-based capital ratios suggest there are still vulnerabilities in euro area banks, some years after the end of the euro area crisis. Additionally, there are some banks in the Asia-Pacific and Other European regions that are flagged by these metrics. These measures inevitably provide a somewhat fuzzy signal, where one can expect false alarms and perhaps overshooting in its predictions in periods of market turbulence. They also do not provide a sense of exactly when problems might arise in banks and may only provide a few months, or even weeks, of advance warning of distress. They are also, obviously, only available for banks that are traded on stock markets. However, these metrics are a valuable surveillance tool for financial stability authorities assessing vulnerabilities in the banking sector.
Related Link: Working Paper
Keywords: International, Banking, Regulatory Capital, Market-based Ratios, Tier 1 Capital, Stress Testing, Capital Ratios, Research, IMF
Previous ArticleFSB on Responses to Consultation on Wind-Down of Trading Portfolios
EIOPA submitted—to the European Parliament, the Council of the European Union, and EC—its 2020, fifth, and last annual report on long-term guarantee measures and measures on equity risk.
The BIS Innovation Hub Swiss Centre, SNB, and the financial infrastructure operator SIX announced the successful completion of a joint proof-of-concept (PoC) experiment as part of the Project Helvetia.
EBA published the final draft regulatory technical standards for calculation of own funds requirements for market risk, under the standardized and internal model approaches of the Fundamental Review of the Trading Book (FRTB) framework.
EIOPA published discussion paper on a methodology for the potential inclusion of climate change in the Solvency II (sometimes also written as SII) standard formula when calculating natural catastrophe underwriting risk.
EU published, in the Official Journal of the European Union, corrigenda to the Directive and the Regulation on the prudential requirements and supervision of investment firms.
MAS proposed amendments to certain regulations, notices, and guidelines arising from the Banking (Amendment) Act 2020.
PRA published a statement that explains when to expect further information on the PRA approach to transposing the Capital Requirements Directive (CRD5), including its approach to revisions to the definition of capital for Pillar 2A.
RBNZ launched consultations on the scope of the Insurance Prudential Supervision Act (IPSA) 2010 and on the associated Insurance Solvency Standards.
SRB published the work program for 2021-2023, setting out a roadmap to further operationalize the Single Resolution Fund and to achieve robust resolvability of banks under its remit over the next three years.
EIOPA is consulting on the relevant ratios to be mandatorily disclosed by insurers and reinsurers falling within the scope of the Non-Financial Reporting Directive as well as on the methodologies to build these ratios.