RDP 1999-09: Australian Banking Risk: The Stock Market's Assessment and the Relationship Between Capital and Asset Volatility 6. Conclusion

This paper has presented a contingent-claim model that translates the market capitalisation of a bank into measures of bank risk. The risk measures obtained from this model provide an alternative to the more readily available measures published in banks' annual reports. If the share market is efficient, with share prices being based on assessment of each firm's fundamental value, the market-based risk measures will more closely approximate the appropriate economic concepts. The accuracy of the risk measures does, however, rely on efficient, well-informed share markets. It is clear that, at times, the market may overreact to developments in the underlying riskiness of individual firms. Moreover, the volatility in market prices means that short-term movements in these risk measures should be viewed with caution.

We find that the market's assessment of banks' capital-asset ratios has risen markedly over the 1990s, after oscillating around a comparatively low level during the 1980s. Against this, the market's assessment of the riskiness of banks' assets also grew quite strongly over the 1990s. When these two offsetting trends are drawn together to derive a model-based estimate of the probability of closure, it is found that the growth in capital outweighs the increase in asset volatility – that is, the estimated average probability of bank closure has fallen in the 1990s relative to its level over most of the 1980s.

Closer investigation of the relationship between each bank's capital-asset ratio and asset volatility suggests that banks increase capital in anticipation of taking on more risk exposures. Such behaviour is consistent with banks being concerned about breaching regulatory capital-adequacy requirements, debt-market discipline and managerial risk aversion. We do not find much support for the notion that moral-hazard considerations are driving banks' behaviour. Our evidence does not suggest that the introduction of the Basel Capital Accord greatly affected the relationship between the capital-asset ratio and asset volatility. Our results do suggest that the relation between capital and asset risk is asymmetric. When the capital-asset ratio is increasing, the relationship between the capital-asset ratio and asset volatility is strongly positive, whereas when the capital-asset ratio is falling the relation between the two variables is weak.