Loan Portfolio Risk and Capital Adequacy: A New Approach to Evaluating the Riskiness of Banks

We develop a Loan Portfolio Risk (LPR) variable that measures time-varying volatility in default risk for a portfolio of bank loans.  An Equity-to-LPR ratio (ELPR) is incrementally important in predicting bank failure up to five years in advance, even after controlling for all the CAMELS variables.  Publicly-listed banks with higher ELPR have lower market-implied costs-of-capital.  ELPR also strongly predicts cross-sectional stock returns under stress conditions.  During the crisis (7/2007-6/2011), a cash-neutral strategy that longs high-ELPR and shorts low-ELPR banks yields a monthly alpha of 3.3% to 4.2%.  We conclude LPR captures key aspects of bank risk missing in risk-weighted-asset calculations.