Supporting the Economy Safely and Soundly – What the Data Say About Risk in the Large Bank Sector

17 Dec 2020
Read Time 3 mins
Categories :
Bank Capital
, Liquidity

Introduction

The past several months have witnessed a severe economic and public health strain on our economy as the COVID-19 pandemic has impacted communities across the country.  During this period, the pandemic has had a variety of unfortunate impacts on our economy, ranging from elevated unemployment to increased strains on specific sectors most affected by the virus’s fallout.  At the same time, the overall health, safety and soundness of large banks has remained strong.  Capital and liquidity levels have remained high throughout the pandemic while large banks have steadily supported the economy through lending and capital raising.  In this post, we briefly review new research from the Federal Reserve Bank of New York (FRBNY) that shows overall risk in the banking sector is low.  Specifically, the authors show that the current level of risk is substantially lower than during the last recession and that in some respects the banking sector has become less risky over the past few months.  These findings are important because they provide a systematic and data-based assessment of the relative strength of the banking sector.

FRBNY Risk Indicators and Trends in Large Bank Risk

Economists at the FRBNY use data for the 50 largest banks to measure the level of bank risk between 2002 and today along four specific dimensions.

  1. Capital Vulnerability – what is the vulnerability of large bank capital levels to a macroeconomic shock?
  2. Fire-Sale Vulnerability – what is the vulnerability of large banks to asset price devaluations resulting from forced sales of illiquid assets?
  3. Liquidity Stress – what is the vulnerability of large banks stemming from a mismatch in the maturity of their assets and liabilities?
  4. Run Vulnerability – what is the vulnerability of large banks to a loss of funding resulting from the inability to roll over short-term liabilities?

The four measures, taken directly from the FRBNY research, are plotted in Figure 1 below.

Figure 1 is a good illustration of the old adage “a picture is worth a thousand words.”  The data clearly show that across each measure, risk in the large banking sector has declined markedly since the last recession.  Simply put, the banking sector that we have today, from a risk perspective, bears little relation to the banking sector that we had a decade or more ago.  To a large degree, this clear trend can be attributed to the fact that large banks are subject to a number of stringent standards for capital and liquidity and these standards have only gotten stronger over the past decade.

The dotted line in the chart coincides with the onset of the COVID-19 pandemic.  Overall, the risk measures do not show any significant increase since that time.  Some of the metrics increase, some decrease and some are roughly unchanged.  Moreover, focusing on the near-term wiggle and waggle of the data over the past several months risks losing the forest for the trees.  Figure 1 clearly shows that large banks have become substantially less risky over the past decade and have continued to remain low risk during these challenging times as they have robustly supported the economy through increased lending and the provision of important financial services such as providing safe, liquid and remotely accessible deposits

Conclusion

Large banks and Financial Services Forum members, in particular, have played an active role in supporting the economy.  Whether it be through supporting small businesses through the Paycheck Protection Program, other business lending, or the work that has been done to raise funding for companies that issue securities in public markets, the nation’s largest banks have been integral to supporting businesses and households in 2020.  Large banks have been doing all of this work while at the same time operating safely and soundly at low risk levels that have declined substantially over the past decade.  Forum members are committed to serving households and business across the country during this pandemic while also remaining committed to sound risk management that will only improve their ability to support the economy during this challenging period.         

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