Niemelä, Jaakko E. (1999). Assessment of capital adequacy in the banking sector: The BIS ratio vs. an altemative multivariate approach. Acta Wasaensia No. 68, 151 p.

The purpose of this study is to investigate the difficulties involved in assessment of capital adequacy of banks by using the BIS ratio, and to suggest an alternative accounting-based approach to forecast the solvency of a bank. The empirical analysis of the thesis is conducted by using data from Finland: First, a time-series analysis of bank assets is employed to investigate the risk-return characteristics of different assets. Second, the empirical relationships between the accounting ratios and insolvency risk is investigated by focussing on the usefulness of the BIS ratio and other accounting ratios.

The empirical results suggest that the association between the BIS ratio and portfolio theoretical measures are far enough from equal to reject the use of the measures for similar purposes. The results indicate that the definition and weighting of the asset risk categories do not correspond closely to a market measure of asset risk. The main reasons for divergence stem from the fact that the BIS ratio ignores interest rate risk as well as the covariance term amongst different assets.

Basic findings about the appropriateness of the BIS ratio and the risk-weights are conclusive: their predictive accuracy in classifying solvent and insolvent banks are relatively low. The results suggest that the BIS ratio will not be used entirely as a measure of capital adequacy and insolvency risk by regulators.

Key words: Capital adequacy, BIS ratio, bank regulation, the risk of bank portfolio.