A Top-Down Approach to Stress-Testing Banks

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