>A better way to measure bank risk (MCKINSEY)

One capital ratio tops others in foreshadowing distress—and it’s not the one that’s traditionally been regulated.

In response to the global banking crisis, regulators and policy makers worldwide have united
behind efforts to increase financial institutions’ minimum capital requirements and to limit
leverage, hoping to reduce the likelihood of future bank distress.1 As of this writing, the debate over proper capital requirements continues, with major implications for the industry and the economy— yet there have been few specifics on which ratios should be targeted or at what levels.

To shed some light on the discussions, we analyzed the global banking crisis of 2007 through
20092 to identify relationships that different types of capital and capital ratios have to bank
distress.3 Our analysis is observational, based on historical data, and not a real-world experiment, which would have required randomly selected financial institutions to hold different capital levels to gauge their effects. As a result, the findings do not definitively establish how institutions might perform in the future if minimum capital ratios were changed, but we believe that the evidence we provide is a valuable input for current policy discussions.

We found that one capital ratio—the ratio of tangible common equity (TCE)4 to risk-weighted
assets—outperforms all others as a predictor of future bank distress. We also found that requiring a minimum leverage ratio would not have offered any insights that couldn’t have been found by studying the right capital ratio. And, not surprising, we found that a higher bar on capital requirements, while reducing the likelihood of bank distress, comes at an increasing cost.

To read the full report: BANK RISK