Capital ratios are not a good tool for identifying problem banks in time to save them, according to a recent study by the Federal Reserve Bank of Boston.
In their report, "The Use of Capital Ratios to Trigger Intervention in Problem Banks: Too Little, Too Late," authors Joe Peek and Eric S. Rosengren argued that capital ratios are a lagging indicator of trouble.
Published in the September/October issue of New England Economic Review, the authors studied failed New England savings and commercial banks between 1988 and 1994. They found that problem institutions often delayed reporting poor capital ratios until after supervisory exams and waited to add to loan-loss reserves until after a problem was identified.
In reaction to the thrift crisis, Congress in 1991 required regulators to segregate banks by capital. Under this "prompt corrective action" scheme, the activities of banks with risk-based capital ratios below 6% or leverage ratios less than 4% are restricted.
But while federal law relies heavily on capital ratios, bank examiners use far more data to identify problem performers early, the authors concluded.
Mr. Peek, an economics professor at Boston College, and Mr. Rosengren, an economist at the Boston Fed, recommended regulators start basing corrective action on the examiners' Camel rating system.
"One possibility is to use Camel rating downgrades, rather than capital ratios, as the trigger for prompt corrective action intervention," the report noted.
The authors also suggested that the prompt corrective action model could be revised to raise the capital-ratio triggers.
Robert Rowe, regulatory counsel for the Independent Bankers Association of America, said banks would be wary about any subjective approach to evaluating performance. Part of the examiners' evaluation includes measuring management quality.
Mr. Rowe said the industry prefers objective measures like capital ratios. "Bankers are more comfortable when you add two and two and get four," he said. "When you start talking about sines and cosines and tangents, they get a little more uncomfortable."
Mr. Shea writes for the Medill News Service.