As shown in Exhibit 1, The Clearing House Bank Conditions Index (TCHBCI) was at 80 in the fourth quarter of 2016 and was little changed relative to the third 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. 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 even 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 of robust economic growth. On the one hand, having extremely safe banks is desirable from a financial stability perspective because 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; values near 0 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 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 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. 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 after the financial crisis, the more stringent capital and liquidity requirements that are part of Basel III, and the U.S. stress tests.
Even though the aggregate index was about unchanged in the fourth quarter of 2016, the capital category increased and the interconnectedness category declined (increasing resilience of the banking sector) while the risk-taking category increased and profitability declined (increasing vulnerability). The increase in the level of resiliency from capital is driven by the rise in the market leverage ratio under stress. Following the presidential election, the equity valuation of banks rose markedly on the expectation of tax reform, infrastructure spending, and the easing of the regulatory burden for banks. The degree of resiliency of the interconnectedness category also improved due to a continuation in the decline of measures of interconnectedness among banks.
In contrast, the risk-taking category registered a slight decrease in resiliency as a result of an easing in lending standards on commercial and industrial loans, but it remained suppressed in part by a very low level of the ratio of loans to deposits and the still ongoing recovery in loan growth. Although the increase in risk-taking reduces the degree of resiliency of the index, reduction in the level of risk-aversion of banks toward historically normal levels could be more supportive of economic growth by expanding credit to bank-dependent borrowers. Meanwhile, bank profitability worsened, further reflecting a continuation of the decline in fee income at banks and still-subdued net interest margins.
The liquidity and asset quality categories of the index were little changed. On the liquidity side, changes in the individual components were mixed. In particular, the gap between the maturity of assets and liabilities continued to increase while banks’ holdings of high-quality liquid assets rose. On the asset quality side, net charge-offs edged up while all other asset quality measured improved slightly over the quarter.
