Assessing banks’ resilience: a complementary approach to stress testing using fair values from banks’ financial statements

Dao, Trang H.; Pugliese, Amedeo; Ronen, Joshua

doi:http://dx.doi.org/10.1111/jbfa.12663

Assessing banks’ resilience: a complementary approach to stress testing using fair values from banks’ financial statements

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Citation

Dao TH, Pugliese A, Ronen J. Assessing banks’ resilience: a complementary approach to stress testing using fair values from banks’ financial statements. J Bus Finance Account. 2022;50(7-8):1206-39. p. DOI: 10.1111/jbfa.12663

Abstract

For more than a decade, supervisory banking authorities in Europe and the United States have sought to assess the resilience of banks to adverse economic episodes to safeguard the financial system's stability. They rely on regulatory capital measures like Common Equity Tier 1 (CET1) relative to risk-weighted assets in the aftermath of potential economic crises. We propose a new measure of banks' resilience based on financial statements. The fair value margin (FVM) is estimated as the difference between the fair value of assets and the book value of liabilities, scaled by the book value of equity. We find that FVM is positively associated with the surplus or shortfall of CET1 resulting from the stress testing results from 2014, 2016 and 2018. To corroborate the relevance of FVM for supervisory authorities, we compare the ability of the loan component of FVM to predict future credit losses with the capital surplus/shortfall metric derived from the stress test. The findings indicate that the fair value of loans predicts net charge-offs better than stress test outcomes. Therefore, we suggest that FVM could be used as a readily available and relatively low-cost tool to assess bank resilience, thus complementing the stress test exercises.