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A Top-down Approach to Stress-testing Banks

Author

Listed:
  • Pavel Kapinos

    () (Division of Insurance and Research, Federal Deposit Insurance Corporation)

  • Oscar A. Mitnik

    () (Office of Strategic Planning and Development Effectiveness, Inter-American Development Bank)

Abstract

Abstract We propose a simple, parsimonious, and easily implementable method for stress-testing banks using a top-down approach that captures the heterogeneous impact of shocks to macroeconomic variables on banks’ capitalization. Our approach relies on a variable selection method to identify the macroeconomic drivers of banking variables as well as the balance sheet and income statement factors that are key in explaining bank heterogeneity in response to macroeconomic shocks. We perform a principal component analysis on the selected variables and show how the principal component factors can be used to make projections, conditional on exogenous paths of macroeconomic variables. We apply our approach, using alternative estimation strategies and assumptions, to the 2013 and 2014 stress tests of medium- and large-size U.S. banks mandated by the Dodd-Frank Act, and obtain stress projections for capitalization measures at the bank-by-bank and industry-wide levels. Our results suggest that accounting for bank heterogeneity yields expected capital shortfalls that can be over 30 percent larger than in the case where heterogeneity is ignored. Furthermore, we find that while capitalization of the U.S. banking industry has improved in recent years, under reasonable assumptions regarding growth in assets and loans, the stress scenarios continue to imply sizable deterioration in banks’ capital positions.

Suggested Citation

  • Pavel Kapinos & Oscar A. Mitnik, 2016. "A Top-down Approach to Stress-testing Banks," Journal of Financial Services Research, Springer;Western Finance Association, vol. 49(2), pages 229-264, June.
  • Handle: RePEc:kap:jfsres:v:49:y:2016:i:2:d:10.1007_s10693-015-0228-8
    DOI: 10.1007/s10693-015-0228-8
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    References listed on IDEAS

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    1. repec:eee:glofin:v:39:y:2019:i:c:p:44-57 is not listed on IDEAS
    2. repec:eee:econom:v:212:y:2019:i:1:p:203-220 is not listed on IDEAS
    3. repec:eee:jfinin:v:34:y:2018:i:c:p:58-90 is not listed on IDEAS
    4. Kok, Christoffer & Mirza, Harun & Pancaro, Cosimo, 2019. "Macro stress testing euro area banks’ fees and commissions," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 61(C), pages 97-119.
    5. International Monetary Fund, 2016. "United Kingdom; Financial Sector Assessment Program-The Bank of England’s Stress Testing Framework-Technical Note," IMF Staff Country Reports 16/162, International Monetary Fund.
    6. Michael W. McCracken & Joseph T. McGillicuddy, 2019. "An empirical investigation of direct and iterated multistep conditional forecasts," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 34(2), pages 181-204, March.
    7. Fischer, Jack R. & McPhail, Joseph E. & Rodrigues, Nathan & Orazem, Peter, 2017. "The Relative Importance of Macroeconomic Shocks, Regional Shocks and Idiosyncratic Risk on Large and Small Banks," ISU General Staff Papers 201707130700001027, Iowa State University, Department of Economics.
    8. Jorge A Chan-Lau, 2017. "Lasso Regressions and Forecasting Models in Applied Stress Testing," IMF Working Papers 17/108, International Monetary Fund.
    9. Szybisz, Martin Andres, 2018. "Banking net income and macroeconomics, from multicollinearity to Granger causality using US data," MPRA Paper 90473, University Library of Munich, Germany.
    10. Gerhard Hambusch & Sherrill Shaffer, 2016. "Forecasting bank leverage: an alternative to regulatory early warning models," Journal of Regulatory Economics, Springer, vol. 50(1), pages 38-69, August.
    11. repec:rfa:aefjnl:v:4:y:2017:i:3:p:155-163 is not listed on IDEAS
    12. Franklin Allen & Itay Goldstein & Julapa Jagtiani & William W. Lang, 2016. "Enhancing Prudential Standards in Financial Regulations," Journal of Financial Services Research, Springer;Western Finance Association, vol. 49(2), pages 133-149, June.
    13. Jiaqi Chen & Michael Tindall, 2016. "The Chen-Tindall system and the lasso operator: improving automatic model performance," Occasional Papers 16-1, Federal Reserve Bank of Dallas.
    14. Schuermann, Til, 2016. "Stress Testing in Wartime and in Peacetime," Working Papers 17-01, University of Pennsylvania, Wharton School, Weiss Center.
    15. Paul Glasserman & Gowtham Tangirala, 2015. "Are the Federal Reserve's Stress Test Results Predictable?," Working Papers 15-02, Office of Financial Research, US Department of the Treasury.
    16. repec:kap:jfsres:v:55:y:2019:i:1:d:10.1007_s10693-017-0275-4 is not listed on IDEAS
    17. Matthew Pritsker, 2017. "Choosing Stress Scenarios for Systemic Risk Through Dimension Reduction," Supervisory Research and Analysis Working Papers RPA 17-4, Federal Reserve Bank of Boston, revised 05 Sep 2017.

    More about this item

    Keywords

    Stress testing; Banking; Dodd-Frank Act.;

    JEL classification:

    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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