Capital Ratios as Predictors of Bank Failure

[...]We focus here on three types of capital ratios—riskweighted,leverage, and gross revenue ratios. For each ratio, weexamine what makes it actually or potentially useful for bankregulation and we ask whether it is indeed significantly relatedto subsequent bank failure. Perhaps not surprisingly, we findthat all three ratios are strongly informative about subsequentfailures. Our analysis suggests that the most complex of theratios—the risk-weighted ratio—is the most effective predictorof failure over long time horizons. However, perhapssomewhat surprisingly, we also find that the risk-weightedratio does not consistently outperform the simpler ratios,particularly with short horizons of less than two years. Over the shorter time periods, the leverage and gross revenue ratios canplay a crucial role as timely backstop thresholds that wouldtrigger regulatory action if breached. They also have theadvantage of being less costly to calculate and report. In thiscontext, the trade-off between regulatory burden andpredictive accuracy may not favor the risk-based measures.[...]