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Book-to-market equity, operating risk, and asset correlations: Implications for Basel capital requirement

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  • Lee, Shih-Cheng
  • Lin, Chien-Ting

Abstract

We examine the effect of book-to-market equity (BE/ME) on asset correlations in the asymptotic single risk factor (ASRF) framework under the Basel II Accord on regulatory capital requirement. Over a sample period from 1988 to 2007, we find that BE/ME is negatively related to asset correlations after controlling for firm size, default probability, and industry effects. Decomposing BE/ME into risks of operating leverage and financial leverage according to Penman et al. (2007) reveals that higher (lower) operating risk are related to lower (higher) asset correlations. Our findings suggest that incorporating risk of operating leverage into the estimation of asset correlations may improve the measurement of a bank's regulatory capital requirement and potentially reduce regulatory capital arbitrage.

Suggested Citation

  • Lee, Shih-Cheng & Lin, Chien-Ting, 2012. "Book-to-market equity, operating risk, and asset correlations: Implications for Basel capital requirement," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(4), pages 973-989.
    • Handle: RePEc:eee:intfin:v:22:y:2012:i:4:p:973-989
    DOI: 10.1016/j.intfin.2012.05.010
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    Cited by:

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    2. Douglas da Rosa München & Herbert Kimura, 2020. "Regulatory Banking Leverage: what do you know?," Working Papers Series 540, Central Bank of Brazil, Research Department.
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    4. M. Dietsch & K. Düllmann & H. Fraisse & P. Koziol & C. Ott, 2016. "Support for the SME Supporting Factor - Multi-country empirical evidence on systematic risk factor for SME loans," Débats économiques et financiers 23, Banque de France.
    5. Ho, Kung-Cheng & Yen, Huang-Ping & Gu, Yan & Shi, Lisi, 2020. "Does societal trust make firms more trustworthy?," Emerging Markets Review, Elsevier, vol. 42(C).
    6. Lee, Shih-Cheng & Lin, Chien-Ting & Tsai, Ming-Shann, 2015. "The pricing of deposit insurance in the presence of systematic risk," Journal of Banking & Finance, Elsevier, vol. 51(C), pages 1-11.

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    More about this item

    Keywords

    Basel Accord; Asset correlation; Book-to-market equity; Operating risk; Default probability;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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