The Relative Importance of Macroeconomic Shocks, Regional Shocks and Idiosyncratic Risk on Large and Small Banks

Mandatory stress testing has been acclaimed by banking regulators as a key response to preventing future financial crises. Each year banks in the United States with over $50 Billion in assets must perform a Comprehensive Capital Analysis and Review (CCAR) . Banks with over $10 Billion are subject to Dodd-Frank Act Stress Testing (DFAST). This study examne the relative importance of international or national macroeconomic shocks, state-level shocks, and idiosyncratic shocks on mortgage rate charge-offs for the universe of all banks for the 2002-2014 period. We find tha banks with over $10 billion in assets have charge-off rates that are very sensitive to macroeconomic shocks, while those aggregate shocks have almost no power to explain the charge-off rates of smaller banks. The results suggests that bank stress tests are appropriately targeted at only the largest banks whose assets are most responsive to macroeconomic shocks.Smaller bank portfolio performance is driven by idiosyncratic shocks of the sort identified in traditional bank examination. State-level shocks are as or more important in explaining small bank charge-off rates as are national shocks. The findings also support the view that the largest banks are subject to added risk compared to small banks because of the high correlation between large bank loan performance and aggregate shocks, implying that large banks require larger capital reserves.