More than a year after the start of 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 during the early stages of the pandemic . In this article, we provide an update to four analytical models that aim to capture different aspects of the vulnerability of the banking system and discuss their perspective on the COVID pandemic. The four models, presented in a Economy of the rue de la LibertÃ© Released in November 2018 and updated annually since then, monitor vulnerabilities in U.S. banking firms and how those vulnerabilities interact to amplify negative shocks.
How do we 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 systemic vulnerability. of the banking system: capital, fire sales, liquidity, and run vulnerability.
- Vulnerability of capital. This index measures the expected level of capitalization of banks after a severe macroeconomic shock. Using the CLASS model, a 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. measures the total amount of capital (in dollars) needed in this scenario to bring each bank’s capital ratio to at least 10%.
- Fire vulnerability. This index measures the extent of systemic ripple losses among banks caused by asset sales on fire in a hypothetical stress scenario. The measure calculates the fraction of aggregate bank capital that would be lost due to the fallout from inflammatory sales. It is based on the article (published in the Finance Review) “Fire sales spillovers and systemic risk. “
- Liquidity stress ratio. This ratio measures the potential lack of liquidity of banks under conditions of liquidity stress. It is defined as the ratio of runnability-adjusted liabilities plus off-balance sheet exposures (with each category of liabilities and off-balance sheet exposures weighted by its expected outflow rate) to liquidity-adjusted assets (with each category of assets weighted by its expected market liquidity).
- Run the vulnerability. This measure measures a bank’s vulnerability to panics, taking into account both liquidity and solvency. The framework considers a shock to assets and a simultaneous loss of funding that results in costly asset liquidations. The run vulnerability of an individual bank calculates the critical fraction of unstable funding that the bank must retain in the stress scenario to avoid insolvency.
How have measures of vulnerability changed over time?
The graph below shows the evolution of the different aspects of vulnerability since 2002, according to the four measures calculated for the fifty largest American bank holding companies (BHC). Dashed lines indicate pre-COVID values ââfor the fourth quarter of 2019.
What were the vulnerability factors of banks during the COVID pandemic?
The COVID pandemic has resulted in significant changes in bank balance sheets compared to 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 occupy a larger share of banks’ balance sheets
Compared to the pre-COVID level in Q4 2019, the aggregate assets of the banks in our sample increased by $ 1.8 trillion in Q1 2020 alone, and then by an additional $ 2 trillion in Q2 2021, for a total increase of over 20 percent during the COVID pandemic so far (left panel of graphic above). Most of that increase came in the form of a $ 1.7 trillion increase in securities, primarily treasury bills and agency mortgage-backed securities, and an increase of 1.5 trillion dollars. trillion dollars in cash (mostly reserves, as shown in the right panel). Combined with a smaller increase in lending of $ 180 billion (after a brief spike in Q1 2020 due to drawdowns on lines of credit), these changes have resulted in a significant increase in the share of liquid assets on banks’ balance sheets. . On the liabilities side, balance sheet expansion took place almost exclusively in the form of deposits, which increased by $ 3.1 trillion. Most of this expansion has occurred in transaction accounts, while term deposits have declined somewhat, leading to an increase in the share of funding from less stable sources.
How did the different vulnerability measures withstand the pandemic?
Capital vulnerability index: After continuing a pre-COVID uptrend 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 early increase of the pandemic was mainly due to an increase in loan provisions and a reduction in the net interest margin. The ensuing decline reflects rising capital levels supported by restrictions on dividends and a decrease in 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 was made by deposits implied an increase in the indebtedness of the banks. The combined increases in relative size and leverage resulted in an increase in the fire sales vulnerability index in the first quarter of 2020. The concurrent increase in liquid assets – which was more pronounced among the larger banks – reduced connectivity, mitigating the increase in fires. -sale vulnerability. Relative size and leverage returned until the end of 2020, but increased somewhat in the first half of 2021.
Liquidity stress ratio: The short-term liquidity ratio declined significantly during the year 2020, largely reflecting an increase in banks’ cash holdings and cash equivalents (mainly reserves). The decrease in the ratio was only partially moderated by the simultaneous increase in deposits. The slight increase in the Liquidity Stress Ratio in the first two quarters of 2021 was driven by a shift from liquidity to less liquid assets, combined with an increase in unused liabilities and a shift to less stable forms of deposit financing.
Run the vulnerability index: The shift to more liquid assets since the start of 2020 initially led to a decline in the Run Vulnerability Index, which hit a new sample low in the third quarter of 2020. Although deposits continued to decline increase, the increase was less stable. types of deposits. Combined with a slight increase in the leverage expected in stressful situations, this reduction in funding stability resulted in an increase in the Running Vulnerability Index, bringing it back to roughly where it was before. COVID.
Lessons learned and future prospects
Globally, the banking system entered the COVID-19 pandemic with historically low vulnerability according to our four measures. While the vulnerability of capital and vulnerability to fire sales briefly increased at the onset of the pandemic in early 2020, all four measures currently indicate low levels of vulnerability, comparable to or lower than the pre-COVID period.
So far, the regulatory changes put in place following the 2007-2009 financial crisis as well as the policy actions 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 linked 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 unannounced sales and funding stress (stress ratio of liquidity and run vulnerability). In addition, the Federal Reserve has restricted dividend payments from large banks from the third quarter of 2020 to the second quarter of 2021 to ensure their resilience. Although provisions for loan losses have increased, the CLASS model is driven by actual charges that have declined significantly during the pandemic, possibly due to loan forgiveness and, more generally, to measures such as the CARES Act, that have helped businesses and consumers weather the crisis. Thus, bank capital was preserved or increased, which directly reduced the vulnerability of capital, but also the vulnerability to fire sales and the vulnerability to execution.
While this policy mix has bolstered financial stability, the unprecedented nature of the COVID-19 pandemic implies lingering uncertainty about potential future losses on bank loans, both in terms of size and timing.
Matteo crosignani is a Senior Economist in the Research and Statistics Group of the Federal Reserve Bank of New York.
Thomas eisenbach is a Senior Economist in the Bank’s Research and Statistics Group.
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.