Modeling the Causes and Manifestation of Bank Stress: An Example from the Financial Crisis

Abstract

In this study, I model the predictors and manifestations of bank stress during the financial crisis using a Multiple Indicator Multiple Cause model. Unlike most early warning models that predict failure probabilities, this paper develops a framework for predicting a broader notion of bank stress that does not rely on regulatory decisions. As such, this method can be easily applied to large institutions, and avoids the complications associated with modeling a regulatory decision such as failure or a CAMELS downgrade. Using out-of-sample incidence of failures and acquisitions, as well as bank reliance on Term Auction Facility funds, I demonstrate that the measure of bank stress generated in this paper accords with other notions of bank-level distress. Finally, by cataloguing predictors of distress during the financial crisis, this paper can help assess the validity of several regulatory proposals recently put forward. I find that those banks and bank holding companies entering the crisis with more Tier 1 capital, more liquid balance sheets, and relatively stable liabilities exhibited lower realizations of stress. These findings support the Basel III mandated increases in banks’ capital adequacy, liquidity, and stable funding.

Keywords: bank stress, early warning model, financial regulation, bank failure, financial crisis

JEL Classification: G21, G28, E58