As shown in Exhibit 1, The Clearing House Bank Conditions Index (TCHBCI) was at 77 in the third quarter of 2016 (the most recent available data as of the publication date), up from 74 in the second quarter. The index provides a quantitative assessment of the resiliency of the U.S. banking sector and is constructed using a wide range of common indicators of bank condition.1 Specifically, TCHBCI synthesizes data on 23 banking indicators, grouped into six categories: capital, liquidity, risk-taking, asset quality, interconnectedness, and profitability. The choice of the variables included in each category follows a large academic literature on banking crises. The Clearing House introduced the index at the end of 2016.
The aggregate index and all the subindexes take values between 0 and 100 to allow for a straightforward comparison of each category over time. A value of the index close to 100 corresponds to a banking sector that is the least vulnerable it has ever been since the first quarter of 1996, the first available data point of the index. In contrast, a value close to 0 implies that the U.S. banking sector is as vulnerable as it has ever been over that interval. While an index value of 100 is consistent with a maximally resilient banking system, it is probably not the level most conducive for robust economic growth. On the one hand, having extremely safe banks is desirable from a financial stability perspective, as vulnerabilities in the banking system amplify and propagate adverse economic and financial shocks, resulting in severe and persistent economic downturns. On the other hand, a banking system that is excessively risk-averse will also have an adverse impact on economic growth over the medium and longer term by restraining credit to borrowers that are bank-dependent (e.g., small businesses) and via higher lending rates on loans to all types of borrowers.
We find in our analysis cited above that GDP growth is maximized when the TCHBCI is about 60. Currently, the TCHBCI is above the optimal level indicated by our statistical model, suggesting that bank caution or banking regulations could be holding up economic growth somewhat. Exhibit 2 plots the heat map of TCHBCI by assigning a color to each quarterly observation of the index. Values near 100 are shown in dark blue, indicating an extremely resilient but frigid banking system, while values near zero are shown in red, indicating the presence of significant vulnerabilities in the banking sector. The most recent observation of the index is light blue, reflecting an elevated level of resiliency of the banking sector.
Exhibit 3 provides the readings on each of the six categories that make up TCHBCI at two points in time: (i) the end of 2008, the nadir of the past crisis and (ii) the most recent quarter. 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 commercial banks to increase their capital and liquidity following the financial crisis, the more stringent capital and liquidity requirements that are part of Basel III, and the U.S. stress tests.
The increase in TCHBCI in the third quarter was driven mainly by continued improvements in asset quality and a continuation in the decline of measures of interconnectedness among banks. The capital and liquidity categories were little changed over the third quarter and remained at record high levels. The risk-taking category remained suppressed in part because of a very low level of the ratio of loans to deposits further supported by a net tightening of lending standards at commercial banks. Lastly, profitability also remained at a relatively low level, reflecting subdued net interest margins and fee income at banks.
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