Judging Banks' Risk by the Profits They Report

In competitive capital markets, portfolios of risky debt claims have high systematic risk exposure in bad times if they offer a high yield in good times. We apply this idea to measurement of bank risk. Rather than trying to directly measure asset risks on the balance sheet — the typical (manipulation-prone) approach in model-based regulation — we explore high rates of profit in good times as an indicator of systematic tail risk exposure. We show empirically, for cross-sections of banks in the financial crisis of 2007–2008 as well as the savings and loan crisis of the 1980s, that high accounting profitability prior to the crisis predicts high systematic tail risk of equity market values during the crisis, and most strongly so if pre-crisis profits arise from non-interest income or are paid out as dividends and managerial compensation. Pre-crisis profit measures do a better job in predicting systematic tail risk than conventional measures based on risk-weighted assets.