As shown in Exhibit 1, the Clearing House Bank Conditions Index (TCHBCI) rose in the third quarter of 2017 and registered its highest level of resiliency since the start of the sample in 1996. Overall, the degree of resilience of the large majority of the subcomponents of the index – capital, risk aversion, asset quality, interconnectedness, and profitability – rose. As shown below, the increase in the level of resiliency is evenly distributed across these five subcomponents. The only exception was the liquidity category, which experienced a slight decline, but it remained close to its highest level of resiliency.
Exhibit 2 depicts the heat map of TCHBCI and for each of the six categories that make up the aggregate index. Values near 100 (higher resiliency) are shown in blue, while values near 0 (higher vulnerability) are shown in red. There are two categories of the index worth emphasizing, capital and risk aversion. The increase in the degree of resilience in the capital category was driven mainly by the increase in V-Lab’s measure of market leverage ratio under stress, which reached its highest value since the second quarter of 2007. The rise in the market leverage under stress indicates that banks’ post-stress leverage ratios have improved in recent quarters, driven by increases in banks’ equity valuations. V-Lab’s measure uses a stress scenario defined by a 40% fall in the stock market over a six-month period.
The rise in risk aversion was mainly driven by a slight decline in the ratio of loans to nominal GDP. Although results from the Federal Reserve’s most recent Senior Loan Officer Opinion Survey indicate that banks experienced weaker demand for business loans in the third quarter, headwinds arising from tighter banking regulations have likely also continued to put downward pressure on loan growth, particularly on loans to borrowers with less-than-perfect or insufficient credit histories. In particular, annual loan growth slowed from 7.25% in 2016 to 4.5% in the third quarter of 2017 (Note: See “TCH’s Take on the Business Loan Growth Conundrum”).
The other categories of the index shifted toward levels consistent with greater resilience in the banking sector. Banks recover from adverse shocks primarily by rebuilding capital through retained earnings and retaining it, so a more profitable banking system is more resilient. Although bank profitability is still subdued relative to historical standards, it rose in the third quarter of 2017, driven by improvements in net interest margins. In addition, all subcomponents of the asset quality and interconnectedness categories improved over the quarter.
In contrast, the slight decline in resiliency observed in the liquidity category was driven by a continued increase in the gap between the maturity of assets and liabilities held by banks. U.S. banks continued to have highly liquid balance sheets and sizable liquidity buffers, and banks’ share of high-quality liquid assets edged up.
Finally, Exhibit 3 provides the readings on each of the six categories that make up TCHBCI at two different points in time: (i) the end of 2008, the nadir of the past crisis, and (ii) the third quarter of 2017. Points plotted near the center of the chart indicate a high degree of vulnerability in that category, while points plotted near the rim indicate high resiliency. As shown by the red line, in the fourth quarter of 2008, the quarter immediately after the failure of Lehman Brothers, almost all categories of the aggregate index were at very low levels, indicating the presence of acute vulnerabilities.
Over the years since the crisis, almost all categories of the index have improved considerably, as shown by the blue line, especially the capital and liquidity positions of U.S. banks. These improvements largely reflect the efforts of banks to increase their capital and liquidity following the financial crisis, the more stringent capital and liquidity requirements that are part of Basel III, improved risk management, and the U.S. stress tests.
