Banking fragility and distress: Macroeconomic determinants

The macroeconomic determinants of banking sector distresses in the Nordic countries, Belgium, Ger-many, Greece, Spain and the UK are analysed using an econometric model estimated on panel data from partly the early 1980s to 2002. The dependent variable is the ratio of banks’ loan losses to lending. In ad-dition to the lagged dependent variable, the explanatory variables include a surprise change in incomes and real interest rates, both variables as a separate cross-product term with lagged aggregate indebtedness. The underlying macroeconomic account that this paper puts forward is that loan losses are basically generated by strong adverse aggregate shocks under high exposure of banks to such shocks. The underlying innovations to income and real interest rates are constructed using published macro-economic forecast for these variables. According to the results, high customer indebtedness combined with adverse macroeco-nomic surprise shocks to income and real interest rates contributed to the distress in banking sector. Loan losses also display strong autoregressive behaviour which might indicate a feedback effect from loan losses back to macroeconomic level in deep recessions. The results can be used in macro stress-testing the banking sector.

Introduction: There are two different purposes and, consequently, two broad lines of approach in banking crisis studies. One line is the attempt to simply find a set of early warning indicators by observing leading indicators which could reliably signal of the threats ahead. Another line is the attempt to find an explanation to the events by theoretical reasoning and econometric testing. This study belongs to the latter group. Increasing our understanding of the macroeconomic factors causing banking crises is one of the goals of this study. We also attempt to gain knowledge of the factors underlying fragility or, for that matter, robustness of the banking sector. This area of research is important from the point of view of the macroprudential analysis conducted by central banks in order to prevent adverse developments to result in a potential systemic event in banking sector, to banking crisis in an extreme case. The results of the study can be used in assessing the resilience of the banking sector in the context of macroprudential analysis, eg in stress testing the banking sector. The results might also be helpful in designing regulatory procedures.

Author: Jarmo Pesola

Source: Research Discussion Papers, Bank of Finland

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