Vulnerability of the banking system through the COVID-19 pandemic

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More than a year into the COVID-19 pandemic, the US banking system has remained stable and appears to have weathered the crisis well, in part due to the effects of policy measures taken at the start of the pandemic. In this article, we provide an update of four analytical models that aim to capture different aspects of banking system vulnerability and discuss their perspective on the COVID pandemic. The four models, presented in a Economy of Liberty Street published in November 2018 and updated annually since then, monitor the vulnerabilities of US banking firms and how these vulnerabilities interact to amplify negative shocks.

How to measure the vulnerability of the banking system?

We consider the following metrics, all based on analytical frameworks developed by New York Fed staff or adapted from academic research, which use public regulatory data on bank holding companies to capture key dimensions of vulnerability systemic banking system: capital, fire sales, liquidity, and run vulnerability.

  • Capital vulnerability. This index measures how well capitalized banks should be after a severe macroeconomic shock. By using the CLASS modela top-down stress test model developed by New York Fed staff, we project banks’ regulatory capital ratios under a macroeconomic scenario equivalent to the 2008 financial crisis. The vulnerability index measures the overall amount capital (in dollars) needed in this scenario to bring the capital ratio of each bank to at least 10%.
  • Vulnerability to sellout. 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 overall bank capital that would be lost due to the fallout from the sellout. It is based on the article (published in the Finance Journal)”Fallout from the clearance sale and systemic risk.”
  • Liquidity constraint ratio. This ratio measures the potential illiquidity of banks under conditions of liquidity stress. 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).
  • Run the 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. An individual bank’s run vulnerability calculates the critical fraction of unstable funding that the bank must retain in the stress scenario to avoid insolvency.

How have vulnerability metrics evolved 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). Dotted lines indicate pre-COVID values ​​in the fourth quarter of 2019.

Source: Authors’ calculations, based on FR Y-9C reports.
Note: Dotted lines indicate values ​​in the fourth quarter of 2019.

What were the vulnerabilities of banks during the COVID pandemic?

The COVID pandemic has resulted in significant changes in banks’ balance sheets from the pre-COVID state. These changes affected the four measures of systemic vulnerability in different ways. The graph below shows the evolution of the key elements of the aggregate balance sheets of the fifty largest BHCs.

Liquid assets make up a larger share of bank balance sheets

Source: Authors’ calculations, based on FR Y-9C reports.
Note: Dotted lines indicate values ​​in the fourth quarter of 2019.

Compared to the pre-COVID level in the fourth quarter of 2019, the aggregate assets of the banks in our sample grew by $1.8 trillion in the first quarter of 2020 alone, then by another $2 trillion in the second quarter of 2021, for an increase total over 20% during the COVID pandemic so far (left panel of graph above). Most of this increase took the form of a $1.7 trillion increase in securities, primarily treasury bills and agency mortgage-backed securities, and a $1.5 trillion increase in dollars in cash (primarily from reserves, as shown in the right panel). Combined with a lower increase in lending of $180 billion (after a brief spike in the first quarter of 2020 due to credit line draws), these changes resulted in a significant increase in the share of liquid assets on corporate balance sheets. banks. On the liability side, balance sheet expansion was almost exclusively in the form of deposits, which increased by $3.1 trillion. Most of this expansion was in transaction accounts, while term deposits declined somewhat, leading to an increase in the share of funding from less stable sources.

How have the different vulnerability measures held up in the pandemic?

Capital Vulnerability Index: After continuing a pre-COVID upward trend in the first half of 2020, the Capital Vulnerability Index declined near the lowest level in the sample during the third quarter of 2020. The increase at the start of the pandemic was mainly due to an increase in loan provisions and a reduction in the net interest margin. The subsequent decline reflects rising capital levels supported by dividend restrictions and lower expected capital depletion, at least in part due to lower net charges from the third quarter of 2020.

Fire-Sale Vulnerability Index: The sudden increase in total assets at the start of 2020 implied an increase in the size of the banking sector relative to the rest of the financial system; the fact that the expansion of the balance sheet took place through deposits implied an increase in the banks’ indebtedness. The combined increases in relative size and leverage led to a peak in the Fire Vulnerability Index in the first quarter of 2020. The concurrent increase in liquid assets – which was more pronounced among the largest banks – reduced connectivity, mitigating the increase in fires. -vulnerability of the sale. Relative size and leverage returned through the end of 2020, but increased somewhat in the first half of 2021.

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). The decrease in the ratio was only partially mitigated by the simultaneous increase in deposits. The slight increase in the liquidity stress ratio in the first two quarters of 2021 is explained by a shift of cash towards less liquid assets, combined with an increase in undrawn commitments and a shift towards forms of deposit financing less stable.

Run the vulnerability index: The shift to more liquid assets since the start of 2020 initially led to a drop in the Run vulnerability index, which reached a new sample low in the third quarter of 2020. Although deposits continued to increase, l increase was less stable. types of deposits. Combined with a slight increase in expected leverage in stressful situations, this reduction in funding stability resulted in an increase in the Run Vulnerability Index, bringing it back to roughly its pre-COVID level.

Lessons learned and future prospects

Overall, the banking system entered the COVID-19 pandemic with historically low vulnerability according to our four measures. While capital vulnerability and sellout vulnerability rose briefly at the onset of the pandemic in early 2020, all four measures currently point to low levels of vulnerability, on par with or below the pre-COVID period.

So far, the regulatory changes put in place following the financial crisis of 2007-2009 as well as the policy measures taken during the COVID-19 pandemic have contributed significantly to the resilience of the banking system. The low levels of our vulnerability measures in the pre-COVID period reflect historically high capital ratios and liquid assets related to post-crisis capital and liquidity regulation.

During the COVID-19 pandemic, the expansion of the Federal Reserve’s balance sheet further increased banks’ liquid assets in the form of reserves, which directly reduced vulnerability to fire sales and funding stress (ratio of liquidity stress and vulnerability to run). In addition, the Federal Reserve has restricted the dividend payments of major banks from the third quarter of 2020 to the second quarter of 2021 to ensure their resilience. Although loan loss provisions have increased, the CLASS model is driven by actual charges which have declined markedly during the pandemic, likely due to loan forbearance and more generally measures such as the CARES Act, that have helped businesses and consumers through the crisis. Thus, bank capital was preserved or increased, which directly reduced capital vulnerability, but also vulnerability to selling off and vulnerability to run.

While this policy mix has bolstered financial stability, the unprecedented nature of the COVID-19 pandemic means continued uncertainty about potential future bank loan losses, both in size and timing.

Matteo Crosignani is a Senior Economist in the Research and Statistics Group at the Federal Reserve Bank of New York.

Thomas Eisenbach is a Senior Economist in the Bank’s Research and Statistics Group.


Warning
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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