The financial stability assessment provided by the Federal Reserve in its recent report to Congress indicates that the strength of the banking system is currently an important source of resilience in the financial system. The quarterly Clearing House Bank Conditions Index (TCHBCI) provides an analytical and concise measurement of the condition of the banking system. In the fourth quarter of 2017, TCHBCI declined slightly (see Exhibit 1) but continues to show an extremely resilient banking system, reflecting in large part the very strong capital and liquidity positions of U.S. banks. Notwithstanding, the TCHBCI remains well above the level that maximizes the contribution of the index in tracking future GDP growth, suggesting that risk-aversion by banks or banking regulations continue to be holding back economic growth somewhat.
Overall, the changes in each of the six subcomponents of the index – capital, liquidity, risk-aversion, asset quality, interconnectedness and profitability – were mixed in the fourth quarter. The capital and liquidity categories of the index experienced small declines but remained close to their highest level of resiliency. The index also showed a modest decrease in risk-aversion by banks and profitability remained subdued. In contrast, the asset quality and interconnectedness categories continued to show improvements in the degree of resiliency.
The slight decrease in the capital category was driven by U.S. tax reform; specifically, the reduction of the value of deferred tax assets as a result of the lower corporate tax rate and the repatriation of overseas earnings. Despite the decrease in regulatory capital ratios due to tax code changes, V-Lab’s measure of market leverage ratio under stress remained very close to the highest value reached in the post-crisis period (shown in the left panel of Exhibit 2). The rise in the market leverage under stress indicates that banks’ post-stress leverage ratios have improved in recent quarters, driven by increases in banks’ equity valuations.
The slight decline in resiliency observed in the liquidity category was driven by a continued increase in the gap between the maturity of assets and liabilities held by banks. In addition, the share of assets financed with short-term wholesale liabilities rose slightly, albeit from the very low post-crisis levels. U.S. banks continued to have highly liquid balance sheets and sizable liquidity buffers and banks’ share of high-quality liquid assets remained very elevated.
The decline in risk aversion was mainly driven by a slight easing of lending standards in the most recent Senior Loan Officer Opinion Survey. The ratio of loans to GDP and the loan to deposit ratio remained about unchanged. Headwinds arising from tighter banking regulations have likely also continued to put downward pressure on loan growth, particularly on loans to borrowers with less-than-perfect or insufficient credit histories. In particular, annual loan growth slowed from 7¼ percent in 2016 to 3½ percent in 2017. Bank profitability remained still somewhat subdued relative to historical standards, in which improvements in net interest margins were offset by relatively weak trading revenue.
All subcomponents under asset quality—net charge-offs, non-performing loans ratio, reserve to loans and reserves to non-performing loans ratio—continued to improve this quarter. Recently, some reports have pointed to higher net charge-off rates on credit card loans at smaller banks, however the rise is quite modest and, as show in the right panel of Exhibit 2, not noticeable in the aggregate data. Lastly, banks became slightly less interconnected in the fourth quarter.
Exhibit 3 summarizes these results by depicting the heat map of TCHBCI for each of the six categories that comprise the aggregate index. Values near 100 (higher resiliency) are shown in blue while values near 0 (higher vulnerability) are shown in red.
Finally, Exhibit 4 provides the readings on each of the six categories that comprise TCHBCI at two different points in time: (i) the end of 2008, the nadir of the past crisis and (ii) the most recent quarter. Points plotted near the center of the chart indicate a high degree of vulnerability in that category while points plotted near the rim indicate high resiliency. As shown by the red line, in the fourth quarter of 2008, the quarter immediately after the failure of Lehman Brothers, almost all categories of the aggregate index were at very low levels indicating the presence of acute vulnerabilities. Over the years since the crisis, almost all categories of the index have improved considerably, as shown by the blue line, especially the capital and liquidity positions of U.S. banks. These improvements largely reflect the efforts of banks to increase their capital and liquidity following the financial crisis, the more stringent capital and liquidity requirements that are part of Basel III, living wills, improved risk management and the U.S. stress tests.
Background information on TCHBCI
The Clearing House introduced TCHBCI at the end of 2016 in order to provide a quantitative assessment of the resilience of the U.S. banking sector using a wide range of common indicators of bank condition and updates the index at a quarterly frequency. The index synthesizes data on 24 banking indicators, grouped into six categories: capital, liquidity, risk-aversion, asset quality, interconnectedness and profitability.
The aggregate index assesses the resilience of the banking sector from the first quarter of 1996 to the present (fourth quarter of 2017) on a scale of 0 to 100. A value of 100 indicates that the banking sector is at its most resilient since the first quarter of 1996; conversely, a value of 0 implies that the U.S. banking sector is at its most vulnerable. Although a value of 100 is associated with a maximally resilient banking system, it is probably not the level most conducive of robust economic growth. On the one hand, having extremely safe banks is desirable from a financial stability perspective as vulnerabilities in the banking system amplify and propagate adverse economic and financial shocks, resulting in severe and persistent economic downturns. On the other hand, a banking system that is excessively risk-averse will also have an adverse impact on economic growth over the medium and longer term by restraining credit to borrowers that are bank-dependent (e.g., small businesses) and via higher lending rates on loans to all types of borrowers. We find that GDP growth is at its highest when the TCHBCI is about 60 (see the dashed line in Exhibit 1). Currently the TCHBCI is close to 100, suggesting that bank caution or banking regulations could be holding back economic growth.