ELPR: A New Measure of Capital Adequacy for Commercial Banks

We develop and evaluate an accounting-based Loan Portfolio Risk (LPR) variable that captures time-varying contagion effects in default risk for a portfolio of bank loans. Our results show that an Equity-to-LPR ratio (ELPR) is additive in predicting bank failure up to five years in advance, after controlling for all the capital adequacy, asset quality, management experience, earnings, liquidity, and sensitivity to market risks (CAMELS) variables as well as other fundamental-based bank risk measures from prior studies. Further, we find that publicly listed banks with higher ELPR have lower market-implied costs of capital, especially under market stress conditions. We conclude that ELPR captures key aspects of bank risk that are missing in current Basel Committee risk-weighted-asset calculations.