Banking System Vulnerability: 2022 Update - Liberty Street Economics

Banking System Vulnerability: 2022 Update – Liberty Street Economics

To assess the vulnerability of the US financial system, it is important to monitor debt and funding risks, both individually and in tandem. In this article, we provide an update of four analytical models aimed at capturing different aspects of banking system vulnerability with data up to 2022:2, assessing how these vulnerabilities have changed since last year. The four models were introduced in a Economy of Liberty Street post in 2018 and have been updated every year since then.

How to measure the vulnerability of the banking system?

Using publicly available regulatory data on bank holding companies, we consider the following metrics, all based on analytical frameworks developed by New York Fed staff or adapted from academic research, to capture key dimensions the vulnerability of the banking system:

  • Capital vulnerability: This index measures how well capitalized banks should be after a severe macroeconomic shock. The measure is constructed using the CLASS model, a top-down stress test model developed by New York Fed staff. Using the CLASS model, we project banks’ regulatory capital ratios under a macroeconomic scenario equivalent to the 2008 financial crisis. The index measures the capital gap, i.e. the total amount capital (in dollars) needed in this scenario to bring the capital ratio of each bank to at least 10%.
  • Vulnerability of the flea market: This index measures the extent of systemic contagion losses among banks caused by asset distress sales under a hypothetical stress scenario. The measure calculates the fraction of the system’s capital that would be lost due to the fallout from the sellout. It is based on the Finance Journal article “Fire-Sale Spillovers and Systemic Risk”, which shows that an individual bank’s contribution to the index predicts its contribution to systemic risk five years in advance.
  • Liquidity constraint ratio: This ratio measures the potential illiquidity of banks under liquidity stress conditions, as evidenced by the mismatch between liquidity outflows from the liability (and off-balance sheet) side and liquidity inflows from the asset side. . It is defined as the ratio of capacity-adjusted liabilities plus off-balance sheet exposures (each category of off-balance sheet commitments and exposures weighted by its expected outflow rate) to cash (each asset class being weighted by its expected market rate). liquidity). The liquidity stress ratio increases when expected funding outflows increase or assets become less liquid.
  • Execution Vulnerability: This measure assesses a bank’s vulnerability to panics, taking into account both liquidity and solvency. The framework considers an asset shock and a simultaneous loss of funding that forces costly asset liquidations. A bank may then become insolvent due to a sufficiently severe asset shock, a sufficiently large loss of funding, or both. An individual bank’s run vulnerability measures the critical fraction of unstable funding that the bank must retain in the stress scenario to avoid insolvency.

How have vulnerability metrics changed over time?

The graph below shows how the different aspects of vulnerability have evolved since 2002, according to the four measures calculated for the fifty largest American bank holding companies (BHC).

Source: Authors’ calculations, based on FR Y-9C reports.

What factors have caused banks to be vulnerable over the past year?

We begin by looking at broad trends in bank balance sheets that affect the four measures of vulnerability. The graph below shows the recent evolution of the aggregate bank balance sheet of the fifty largest BHCs.

Source: Authors’ calculations, based on FR Y-9C reports.

The COVID pandemic has led to a strong expansion of bank balance sheets in 2020 thanks to an increase in cash and securities, financed by deposits. Since the last update of our metrics (covering data through 2021:Q2), balance sheet growth has slowed through 2022:Q1 and turned negative in 2022:Q2.

Among the balance sheet components, loans have increased since 2021:Q2, while securities have been flat and cash has declined, in line with lower overall reserves. Overall, these changes moderately reduced the liquidity composition of bank assets.

On the liability side, total deposits mostly reflected changes in total assets, increasing relative to 2021:Q2 with a moderate shift from the most stable to the least stable categories of deposits. Combined with high capital distributions, capital ratios have returned to pre-COVID levels.

How have the different vulnerability measures evolved?

All four vulnerability indices are higher in 2022:Q2 than they were in 2021:Q2 (first chart):

  • Capital Vulnerability Index: The Capital Vulnerability Index, registering a stress scenario capital shortfall of $54.7 billion from 2022:Q2, resumed its pre-COVID upward trend since 2021:Q3, after hovering around a full sample low of $8 billion from mid-2020 to mid-2020-2021. This dynamic largely reflects the evolution of banks’ capital. The low vulnerability amid the pandemic was mainly due to restrictions on dividends and lower provisions for loan losses. The subsequent increase in the index reflects a lower return on trading assets, higher non-interest expenses and higher distributions following the relaxation of restrictions on dividends.
  • Fire-Sale Vulnerability Index: The clearance sale vulnerability index briefly increased at the start of the pandemic in 2020: 1 before returning until the end of 2020. Since then, clearance sale vulnerability has increased, surpassing its peak in 2020: 1. All three underlying components have increased: bank size (relative to the rest of the financial sector), overall leverage (lower unweighted capital ratios) and connectivity (concentration among banks of illiquid assets, leverage and size). Overall, the 2022 sellout vulnerability index: 2 is above its pre-COVID level, at a level last seen in 2012, but still below its historical highs.
  • Liquidity stress ratio: The liquidity stress ratio decreased significantly over the course of 2020, largely reflecting an increase in banks’ holdings of cash and cash equivalents (mainly reserves) driven by the Bank’s asset purchase programs. Federal Reserve. The decline in the ratio was only partially mitigated by the simultaneous increase in deposits. The liquidity stress ratio remained stable in 2021 and started to increase in 2022. The increase in the ratio in the first half of 2022 was driven by a shift of cash and cash equivalents to less liquid assets, an increase unused commitments and a change from stable to unstable deposit funding. Despite the recent upward trend, the liquidity stress ratio remains at historically low levels, with a value in 2022: 2 that is 10% lower than its pre-COVID level.
  • Run the vulnerability index: The Stroke Vulnerability Index briefly declined in 2020 with the shift to more liquid assets at the onset of the COVID pandemic, before returning in 2021 and rising since then. Among the underlying components, assets have become less liquid compared to 2021:Q2, funding has become more volatile, and predicted stress leverage has increased, contributing to increased run vulnerability. Overall, the Stroke Vulnerability Index has risen above its pre-COVID level, but is still significantly below its historical highs.

Summary and future outlook

Overall, the banking system has historically low vulnerability across our four measures, reflecting historically high capital ratios and liquid assets related to post-crisis capital and liquidity regulations and balance sheet policy. the Federal Reserve. After the disruptions related to the COVID pandemic, all four vulnerability metrics are now on an uptrend, with the capital, fire-sale and run vulnerability indices all above the lows reached in the mid-2010s.

Going forward, we expect vulnerability metrics to be determined by two main factors. First, a continued shrinkage of the Federal Reserve’s balance sheet will likely lead to a decline in banks’ cash holdings, thus triggering a further shift towards less liquid assets. This adjustment would prolong the increases in the vulnerability index to clearance sales, the liquidity stress ratio and the vulnerability index to racing. Second, if bank capital ratios continued to decline, we would expect further increases in the capital vulnerability index, sellout vulnerability index, and run vulnerability index.

Photo: portrait of Matteo Crosignani

Matteo Crosignani is a Financial Research Economist in Nonbank Financial Institutions Studies in the Research and Statistics Group at the Federal Reserve Bank of New York.

Photo by Thomas Eisenbach

Thomas M. Eisenbach is a Financial Research Advisor in Money and Payments Studies in the Research and Statistics Group at the Federal Reserve Bank of New York.

Photo: portrait of Fulvia Fringuellotti

Fulvia Fringuellotti is a Financial Research Economist in Nonbank Financial Institutions Studies in the Research and Statistics Group at the Federal Reserve Bank of New York.

How to cite this article:
Matteo Crosignani, Thomas Eisenbach and Fulvia Fringuellotti, “Banking System Vulnerability: 2022 Update”, Federal Reserve Bank of New York Economy of Liberty StreetNovember 14, 2022,

The opinions expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

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