Banks’ Capital Ratios Help Determine Asset Prices

Building on an earlier model by He and Stanford’s Arvind Krishnamurthy, which demonstrated that intermediaries with a low capital ratio become more cautious about investing in risky assets, He, Kelly, and Manela focused on the primary dealer counterparties of the New York Federal Reserve. Primary dealers are institutions that deal directly with the Fed, including purchasing federal debt at auction and selling it to clients; they include systemically important banks such as Goldman Sachs, Deutsche Bank, and J. P. Morgan.

The researchers constructed a measure of banks’ capital ratios and find that some assets are more sensitive to this capital risk than others. The authors call this sensitivity a “capital beta.” He and Krishnamurthy’s earlier model suggests that the expected return on assets is not just a function of market betas. Banks will hold assets with a high capital beta only when compensated for the capital risk.

He, Kelly, and Manela test the relationship between the capital beta and expected returns in seven asset classes: stocks, US government and corporate bonds, other sovereign bonds, options, credit default swaps, commodities, and foreign exchange. They find that the premiums rewarding capital risk for five of the seven asset classes range from 7 percent to 11 percent, with foreign exchange and options being somewhat higher. The data are consistent with a capital-risk premium of 9 percent for all asset classes.

The research suggests that the dealers do, in fact, act as the pivotal players, setting asset prices on the margin. A large shock to the banking system, or one that hits several markets at once so that it deals a serious blow to intermediaries’ capital, may be transferred to other markets, affecting the system as a whole. If financial stress is an important source of risk and cannot be diversified away, assets that are more sensitive to risk should, on average, earn a risk premium.