A Top-Down Approach to Stress-Testing Banks

55 Pages Posted: 23 Jul 2014 Last revised: 27 May 2015

Pavel S. Kapinos

Federal Reserve Bank of Dallas--Financial Industry Studies

Oscar A. Mitnik

Inter-American Development Bank; IZA Institute of Labor Economics

Multiple version iconThere are 2 versions of this paper

Date Written: March 17, 2015

Abstract

We propose a simple, parsimonious, and easily implementable method for stress-testing banks using a top-down approach that evaluates the impact of shocks to macroeconomic variables on banks' capitalization. Our method relies on a variable selection method to identify the macroeconomic drivers of banking variables combined with a principal component analysis. We show how it can be used to make projections, conditional on exogenous paths of macroeconomic variables. We also rely on this approach to identify the balance sheet and income statement factors that are key in explaining bank heterogeneity in response to macroeconomic shocks. We apply our method, using alternative estimation strategies and assumptions, to the 2013 and 2014 stress tests of medium- and large-size U.S. banks mandated by the Dodd-Frank Act, and obtain stress projections for capitalization measures at the bank-by-bank and industry-wide levels. Our results suggest that while capitalization of the U.S. banking industry has improved in recent years, under reasonable assumptions regarding growth in assets and loans, the stress scenarios can imply sizable deterioration in banks' capital positions.

Keywords: stress testing, banking, Dodd-Frank Act

JEL Classification: G17, G21, G28

Suggested Citation

Kapinos, Pavel S. and Mitnik, Oscar A., A Top-Down Approach to Stress-Testing Banks (March 17, 2015). FDIC Center for Financial Research Paper No. 2015-02. Available at SSRN: https://ssrn.com/abstract=2469425 or http://dx.doi.org/10.2139/ssrn.2469425

Pavel S. Kapinos (Contact Author)

Federal Reserve Bank of Dallas--Financial Industry Studies ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

HOME PAGE: http://https://sites.google.com/site/pavelkapinos/

Oscar A. Mitnik

Inter-American Development Bank ( email )

1300 New York Ave, NW
Washington, DC 20577
United States

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

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