The Bank Conditions Index (BCI), which provides an analytical and concise measurement of the condition of the U.S. banking system, was roughly unchanged in the first quarter of 2018 and continues to show an extremely resilient banking system, reflecting in large part the very strong capital and liquidity positions of U.S. banks (Exhibit 1).
In the fourth quarter of 2017, the index registered a decline in profitability and capital driven by changes to the U.S. tax code – specifically, the reduction of the value of deferred tax assets and the repatriation of overseas earnings. In the first quarter of this year, profitability recovered because of the lower corporate tax rate, and the liquidity and risk-aversion categories also increased their degree of resiliency. Overall, the BCI 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.
Exhibit 2 depicts the heat map of the BCI for each of the six categories that make up the aggregate index. Values near 100 (higher resiliency) are shown in blue; values near 0 (higher vulnerability) are shown in red. 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 first quarter of 2018. In particular, the risk aversion, liquidity, and profitability categories showed improvements in their degree of resiliency. In contrast, interconnectedness declined in the degree of resiliency. Lastly, the capital and asset-quality categories of the index were about unchanged relative to the previous quarter.
The increase in resiliency observed in the liquidity category was driven by a decline in the gap between the maturity of assets and liabilities held by banks. The maturity gap had been rising since the end of 2014, and a recent BPI blog post1 discussed the possibility that the Fed’s stress tests were incentivizing banks to hold longer-term assets, such as longer-term fixed-rate government securities, to improve their performance in the stress tests. The share of assets financed with short-term wholesale liabilities also declined slightly this quarter. In summary, 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. Meanwhile, bank profitability recovered due to the reduction in the corporate tax rate and an increase in non-interest income and net interest margins, but it remained still somewhat subdued relative to historical standards.2
The increase in risk aversion was mainly driven by a decline in the loan-to-GDP ratio gap. Currently, the gap is well below its long-run trend and declined further in the first quarter of 2018, signaling a lackluster growth rate of loans relative to the size of the economy. Headwinds arising from tighter banking regulations3 have likely continued to put downward pressure on loan growth, particularly on loans to borrowers with less-than-perfect or insufficient credit histories. That said, total loans grew at an annual rate of 5.75% in the first quarter of 2018.
The decrease in resiliency of the interconnectedness category was driven by an increase in exposures to financial entities, defined as the ratio of loans made to other depository institutions, repos, and federal funds sold to total assets. According to several industry reports and discussions at a recent BPI symposium on money market conditions, the increase in interconnectedness is in most part driven by an increase in repo balances at primary dealers because they provide financing for an increased supply of Treasury bills.
The capital category was about unchanged in the first quarter, on net. Market leverage under stress rose markedly as a result of a reduction in the dynamic correlation between each bank and the market index; however, it was offset by a decline in regulatory capital ratios due to an increase in risk-weighted assets under the standardized approach. In addition, accumulated other comprehensive income – which is part of common equity Tier 1 capital for advanced-approaches banks – also declined due to a rise in longer-term interest rates. The asset-quality subcomponent was also little changed this quarter. Improvements in the nonperforming loans ratio, reserve to loans, and reserves to nonperforming loans ratio were almost offset by an increase in net charge-offs. n