Stress testing of the stability of the Italian banking system: a VAR approach
AbstractWith the aim of contributing to the use of stress testing techniques, by now a commonly-used practice adopted by the financial community to understand the determinants of financial instability, and to measure the size of financial risk, this work represents an application of macro stress testing to the Italian banking system. The paper tries to provide an answer to two interrelated questions. Whether, and the extent to which, procyclicality is a prominent feature of banks’ soundness and whether exogenous, or policy induced, tightening of monetary conditions (sharp and sustained increases in the interest rate and/or appreciation of the exchange rate) significantly increases banks’ fragility. The task is accomplished by the estimation of three alternative VAR models each using different indicators of banks’ soundness: the ratio of non performing loans (flow and stock data) and interest margins to outstanding loans. Two main conclusions emerge. First: the behaviour of either non performing loans or interest margins is only weakly procyclical: i.e. that the solidity of Italian banks could be seriously undermined only in case of falls in output far more severe than in any previous recession since the end of the World War II. The preoccupation expressed by the literature about the dangers of financial procyclicality seems, therefore, grossly exaggerated in the case of Italy. Second: in a hypothetical scenario where monetary conditions are drastically tightened our banks’ soundness indicators exhibit little variations. In this case too the importance attached by the literature to exchange rate swings, or monetary tightening more generally, for the setting off of financial crises is vastly overstated.
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Bibliographic InfoPaper provided by Universita di Modena e Reggio Emilia, Dipartimento di Economia Politica in its series Heterogeneity and monetary policy with number 0703.
Length: pages 46
Date of creation: Mar 2007
Date of revision:
banking crises; financial crises; procyclicality; profitability; stress testing; VAR;
Find related papers by JEL classification:
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-03-17 (All new papers)
- NEP-BAN-2007-03-17 (Banking)
- NEP-EEC-2007-03-17 (European Economics)
- NEP-FMK-2007-03-17 (Financial Markets)
- NEP-IFN-2007-03-17 (International Finance)
- NEP-MAC-2007-03-17 (Macroeconomics)
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