Turbulent times can leave anyone feeling a little raw, and banks are no exception.
Last year’s runs raised the flags on the resilience of the banking system and luckily the smart people at the Fed of New York know how to measure bank vulnerability and have just released the 2024 metrics.
They look at vulnerability from four nifty angles:
- Capital—this index asks how far banks are from the capital ratio they would need to withstand a stress situation like the 2008 financial crisis or the 2022 interest rate hikes, and the answer is not that far and closer than last year at the same time.
- Fire-Sale—this index asks how much banks would lose as a fraction of their capital if there was a system-wide fire-sale of assets. In other words, it adjusts the capital for unrealized losses (or gains) by marking all assets at fair value. As we have talked about before, interest rate hikes do lead to unrealized losses and played a main character in bringing down SVB. While this index has also gotten better over the past year it is still well above the low-interest-rate decade from 2012-2022.
- Liquidity Stress—ah, there’s a ratio that goes straight to the heart of the matter. It measures the mismatch between liquidity-adjusted outflows (liabilities+) and inflows (fair-valued assets). Where this ratio fell to its lowest level in this millennium from 2020-2022, it has since picked right back up to pre-pandemic levels.
- Run—this index combines sensitivity to asset value shocks and sensitivity to loss of funding in one number. This index also rose sharply in 2022 but has since stabilized some.
Apart from the resilience getting a bit better over the past year, but not as good as the decade up till 2022 which is all a bit let’s-see-where-this-goes, the most illuminating aspect of the vulnerability numbers is that for all the concern and handwringing about capital adequacy, the upset of 2023 was nothing compared to the GFC in 2008. The banking system is in far better shape now.
“That’s what we’ve been saying all along,” one imagines Team Bank crying and throwing up their hands with exasperation.
“And also, asking us to hold more capital is just gonna make us more codependent.” Well, The Risk Report might have made that one up.
But the counterpoint has been made, that a higher capital ratio or even a fixed capital ratio will have undesired effects on banks because it makes them rigid and risk-averse and therefore not able to resolve banking system crises on their own.
Recently that sentiment was put forth in an FT interview with Steven Kelly, who is the associate director at the Yale Program for Financial Stability.
Kelly posits that the goal of bank regulation—and Basel III, end game in particular—should not be to prevent financial crises at all costs, but rather balance the probability of a crisis with the cost to the economy and the banking system.
He goes further to say that such balance can only be achieved with more wiggle room in the regulatory oversight because otherwise banks will keep optimizing to the rules and not necessarily to what is best for the bank or the system.
Source for Bank System Vulnerability Indices: Matteo Crosignani, Thomas Eisenbach, and Fulvia Fringuellotti, “Banking System Vulnerability: 2024 Update,” Federal Reserve Bank of New York Liberty Street Economics, November 12, 2024.
Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.
This article is part of the FRG Risk Report, published weekly on the FRG blog. To read other entries of the Risk Report, visit frgrisk.com/category/risk-report/.