Using the market value of equity to signal banking sector vulnerabilities

Abstract

Equity market valuations of bank capital have been found to be better than regulatory capital ratios, and other metrics, in spotting problem banks. This paper illustrates how marketbased ratios could be used as part of the surveillance toolkit to assess vulnerabilities in the banking sector. While the measures may provide some false signals, from the point of view of an authority tasked with assessing systemic risk, it is better to have a strategy for identifying potential difficulties — even if sometimes everything turns out to be fine — than not being able to spot anything before problems affect the banking system.