Book-to-Market Equity, Asset Correlations and the Basel Capital Requirement

Authors

  • Shih-Cheng Lee,

  • Chien-Ting Lin,

  • Min-Teh Yu

    Corresponding author
    • Address for correspondence: Dr. Min-Teh Yu, Institute of Finance, National Chiao Tung University and RIRC, National Cheng Chi University, Taiwan.

      e-mail: mtyu@nctu.edu.tw

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    • The first author is at the Department of Finance, Yuan Ze University, Chung-Li, Taiwan, and the University of Adelaide Business School, Australia. The second author is at the School of Accounting, Economics and Finance, Deakin University, Australia. The third author is at the Institute of Finance, National Chiao Tung University, Taiwan. The authors would like to thank Peter F. Pope (the Editor) and most especially an anonymous referee for comments and suggestions that have greatly improved the paper. (Paper received August, 2011, revised version accepted March, 2013).


Abstract

This paper examines the effect of book-to-market equity (BE/ME) on asset correlations under the Basel capital requirement. We find that BE/ME captures variations in asset correlations after controlling for firm size, default probability and industry effects from 1987 to 2011. Obligors with higher BE/ME exhibit lower asset correlations compared to those with lower BE/ME. Decomposing BE/ME into assets-in-place and growth options based on the asset pricing literature shows that obligors with more assets-in-place or more fixed assets have higher BE/ME and lower asset correlations than those with more growth options. Overall, our findings suggest that BE/ME is an additional important factor that may improve the estimates of asset correlations and thereby banks’ capital adequacy.

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