RDP 2001-06: The Effect of Macroeconomic Conditions on Banks' Risk and Profitability 5. Conclusion

The relative importance of system-wide and firm-specific factors influences the stability of the overall financial system and the way in which shocks are transmitted through the financial system and the broader economy. The relative weight of these two sources of variation also bears on policy prescriptions aimed at strengthening financial system stability. While micro-level risks are reduced by individual-institution prudential supervision (including controls such as capital adequacy requirements and limits on lending concentrations), system-wide risk is minimised by maintaining sound macroeconomic policy.

The size of, and variation in, individual-institution differences highlights the contribution that individual-institution prudential supervision can make to financial system stability. It is neither possible, nor desirable, to require that all institutions conform to the same risk profile. However, to the extent that supervision reins in risk-taking by those institutions lying at the high-risk extreme of the spectrum, this is likely to strengthen the financial system as a whole. The effect of economic variables on banks' performance also suggests that prudential policies that strengthen incentives for banks to act in a counter-cyclical way (for example, by encouraging banks to increase their capital ratios as economy-wide gearing rises) can effectively reduce the risk of system-wide instability.

The strength of the relation between the macroeconomic variables considered and banks' risk indicates that macroeconomic policy has an important role to play in providing a stable environment for banks to operate in. The extent to which monetary policy, in particular, should be set with an eye towards financial system stability, rather than focusing solely on price stability, remains controversial. Nevertheless, our results suggest that sound monetary policy is an important pre-condition for financial system stability.

The simple models presented in this paper provide a first pass at assessing how macroeconomic conditions may affect financial system risk. The relatively small datasets available (both in terms of the number of banks and the length of time) constrain the scope of empirical analysis. Our simplistic analysis, which assumes that each bank responds to macroeconomic developments in the same way, fails to address the interaction between macroeconomic and individual-firm effects, and therefore is likely to understate the effect of the macroeconomy on banks' credit risk and profitability. Since both the level and dispersion of impaired assets and banking profitability move with the economic cycle, some portion of the observed interbank variation may also be due to macroeconomic effects. The inclusion of bank-specific variables (such as bank size, loan concentration, asset composition and the speed of lending growth) into the modelling framework would allow a more complete investigation of the relative contribution of individual-bank characteristics and movement in macroeconomic variables on overall bank risk and performance.