To assess the vulnerability of the U.S. financial system, it is important to monitor leverage and funding risks—both individually and in tandem. In this post, we provide an update of four analytical models aimed at capturing different aspects of banking system vulnerability with data through 2022:Q2, assessing how these vulnerabilities have changed since last year. The four models were introduced in a Liberty Street Economics post in 2018 and have been updated annually since then.
Capital Vulnerability Index: The Capital Vulnerability Index, registering a stress-scenario capital gap of $54.7 billion as of 2022:Q2, has resumed its pre-COVID uptrend since 2021:Q3, after hovering around a full-sample low of $8 billion from mid-2020 to mid-2021. This dynamic largely reflects the evolution of bank capital. The low vulnerability in the midst of the pandemic was mostly due to dividend restrictions and a drop in loan loss provisions. The subsequent increase of the index reflects a lower return on trading assets, higher noninterest expenses, and higher distributions following the relaxation of dividend restrictions.
Fire-Sale Vulnerability Index: The fire-sale vulnerability index briefly spiked at the onset of the pandemic in 2020:Q1 before reverting through the end of 2020. Since then, fire-sale vulnerability has increased, surpassing its spike in 2020:Q1. All three underlying components have increased: banks’ size (relative to the rest of the financial sector), aggregate leverage (lower unweighted capital ratios), and connectedness (concentration across banks of illiquid assets, leverage, and size). Overall, the fire-sale vulnerability index in 2022:Q2 is above its pre-COVID level, at a level last seen in 2012, but remains below its historical highs.
Liquidity Stress Ratio: The Liquidity Stress Ratio fell significantly over the course of 2020, largely reflecting an increase in banks’ holdings of cash and cash equivalents (mostly reserves) driven by the Federal Reserve’s asset purchase programs. The ratio’s decline has been only partially moderated by the simultaneous increase in deposits. The Liquidity Stress Ratio remained flat in 2021 and began to rise in 2022. The increase of the ratio in the first half of 2022 was driven by a shift from cash and cash equivalents toward less liquid assets, an increase in unused commitments, and a shift 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:Q2 that is 10 percent below its pre-COVID level.
Run Vulnerability Index: The run vulnerability index briefly declined in 2020 with the shift to more liquid assets at the beginning of the COVID pandemic, before reverting in 2021 and increasing since then. Among the underlying components, assets have become less liquid compared to 2021:Q2, funding has become more unstable, and predicted stress leverage has increased—all contributing to the increase in run vulnerability. Overall, the run vulnerability index has increased above its pre-COVID level but is still considerably below its historical highs.
The full article is available at https://libertystreeteconomics.newyorkfed.org/2022/11/banking-system-vulnerability-2022-update/