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

Shih-Cheng Lee and Chien-Ting Lin

Journal of International Financial Markets, Institutions and Money, 2012, vol. 22, issue 4, 973-989

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.

Keywords: Basel Accord; Asset correlation; Book-to-market equity; Operating risk; Default probability (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:intfin:v:22:y:2012:i:4:p:973-989

DOI: 10.1016/j.intfin.2012.05.010

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