Are regulatory capital adequacy ratios good indicators of bank failure? Evidence from US banks

- Tier 1 capital ratio is insignificantly negatively associated with bank distress. However, the association is significant only when bank holding companies fall below the well-capitalization ratio of 6%.
- The association between regulatory capital ratios and bank distress differs in the period of the financial crisis of 2007-2009.
- Regulators should consider validating the regulatory well-capitalization benchmark, especially in periods of economic turmoil.
- Market-based default probability measures and bank-specific characteristics prove relatively more significant in association with bank distress.

Motivated by massive bank failures during the financial crisis, this paper examines whether capital adequacy ratios required by regulators are associated with bank failure. It investigates whether the association is affected by the bank's proximity to the minimum required capital ratios. If results show a significant association between regulatory capital and failure of banks falling below the minimum capital ratios, then the ratios are set at an adequate level. Examining a sample of 560 US bank holding companies for the period 2003-2009, results reveal that the association between the core (Tier 1) capital ratio and bank failure becomes significant only if the bank holding company has a Tier 1 capital ratio of less than 6%. This is the level below which US bank regulators do not regard banks as being well capitalized. During the financial crisis period of 2007-2009, there is a significant association only when the criterion is set at or above 8%. Market-based probability of default is more significantly associated with failure relative to Tier 1 capital ratio. The findings of this paper are relevant to regulatory policy discussions and Basel III deliberations on capital adequacy at times of financial turmoil.