Banks’ Capital: The Relevance of Market Signals

Abstract

The financial turmoil has put into question the effectiveness of the existing regulatory framework for banks. Regulators reacted to the crisis by imposing new capital requirements to achieve both higher and better quality capital, but the theoretical/conceptual framework behind banks’ regulation has remained unchanged. Risk Weighted Assets (RWAs) to total assets ratio is the key prudential indicator used to detect/forecast banks’ risk. In this paper we use a multi-country panel of European banks to assess the predicting power of RWAs in terms of both banks’ risk and unexpected losses. We show that during the crisis market prices (notably price-to-book ratios) were more effective in predicting banks’ future distress/losses. Therefore we argue that market-based measures of risk should play a significant role in banks’ regulation and supervision.