from Liberty Street Economics
— this post authored by Dong Beom Choi, Fernando Duarte, Thomas M. Eisenbach, and James Vickery
In the wake of the 2007-09 financial crisis, a wide range of new regulations have been introduced to improve the stability of the banking system. But has the banking system become safer since the crisis?
In this post, we provide a new perspective on this question by employing four analytical models, each measuring a different aspect of banking system vulnerability, to evaluate how system stability has evolved over the past decade.
Vulnerability Measures
We study four measures of banking system vulnerability based on models developed by Federal Reserve Bank of New York staff or adapted from academic research.
Capital vulnerability: This index measures how well capitalized banks are projected to be after a severe macroeconomic shock. The measure is constructed using the CLASS model, a top-down stress testing model developed by New York Fed staff. Using the CLASS model, we project the regulatory capital ratio of each large banking organization under a macroeconomic scenario equivalent to the 2008 financial crisis. The vulnerability index measures the aggregate amount of capital (in dollars) that would be needed under that scenario to bring each banking firm’s capital ratio up to at least 10 percent.
Fire sale vulnerability: This index measures the magnitude of systemic spillover losses among banks caused by asset fire sales under hypothetical stress scenarios, expressed as a fraction of system capital. In this New York Fed staff report, we show that an individual bank’s contribution to the index predicts its contribution to systemic risk five years in advance.
Liquidity stress ratio: This ratio captures the liquidity mismatch between a bank’s assets and liabilities during a liquidity stress scenario. It is defined as the ratio of expected cash outflows in times of stress to the size of the bank’s portfolio of liquid assets. If the ratio is high, this means that there may be insufficient liquid assets that can be liquidated to meet expected outflows in stressful conditions.
Run vulnerability: This measure gauges banks’ vulnerability to runs, taking into account both liquidity and solvency. It combines a theoretical framework with projections of stress deterioration in bank capital from the CLASS model. An individual bank’s run vulnerability is the critical fraction of unstable funding that the bank needs to retain to prevent insolvency.
