The ESRB paper that presents an analytical framework that assesses and quantifies the potential impact of a bank failure on the real economy through the lending function. Through this, the paper aims to contribute to the ongoing debate about how to perform the Public Interest Assessment, which is required by the European regulatory framework during resolution planning phase as well as when a bank is failing or likely to fail. The framework is harmonized across jurisdictions in the Banking Union and aims to improve the quantitative leg of the public interest assessment, to be coupled with qualitative elements.
The paper assesses the possible impact of a bank failure on financial stability by focusing on the credit channel—that is, the harm to economic growth that could stem from the temporary credit shortfall caused by the abrupt closure of a lender. The analysis implicitly assumes that a resolution of the lender would minimize the repercussion on its lending function. The methodology entails a first step, whereby the potential credit shortfall from the abrupt closure of the lender is quantified leveraging EU-harmonized banking databases. In the second step, estimation is done for the country-specific impact of any given credit shortfall onto real economic variables, such as GDP, value added or total employment. This second step exploits either a Factor Augmented Vector Autoregressive, or FAVAR, approach or a micro-econometric model. Once the economic impact of a specific bank failure are estimated, appropriate reference values are provided to benchmark the economic relevance of the estimated outcomes. It was found that such a harmonized method can be applied consistently across the Banking Union and that it will become more robust as soon as more granular and longer time series become available.
For mid-size (“grey area” or “middle class”) banks, the implementation of this common analytical framework could provide useful insights to reduce the uncertainty on whether resolution is in the public interest—that is, an assessment of whether the failure of the institution would endanger financial stability via a significant adverse impact on the real economy. The proposed framework has the advantage of being highly flexible; for example, it can be easily adapted to estimate regional (rather than national) impact. Even though such a framework aims to enhance the financial stability assessment in the public interest assessment, it has limitations. This is because this framework only deals with the credit channel linking a bank failure to the real economy and considers only the impact on the real economy, which is just one of the many aspects of the financial stability consequences of a bank failure.
Related Link: Working Paper (PDF)
Keywords: Europe EU Banking Credit Risk BRRD SRMR Resolution Framework Public Interest Assessment Lending Banking Union Crisis Management Framework Resolution Planning Basel ESRB
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