Stress Testing of the Stability of the Italian Banking System: A VAR Approach

With the aim of contributing to the use of stress testing techniques, by now a commonly used practice adopted by the financial community to understand the determinants of financial instability, and to measure the size of financial risk, this paper represents an application of macro stress testing to the Italian banking system. The paper tries to provide an answer to two interrelated questions. Whether, and the extent to which, procyclicality is a prominent feature of banks’ soundness and whether exogenous, or policy induced, tightening of monetary conditions (sharp and sustained increases in the interest rate and/or appreciation of the exchange rate) significantly increases banks’ fragility. The task is accomplished by the estimation of three alternative VAR models, each using different indicators of banks’ soundness: the ratio of non- performing loans (flow and stock data) and interest margins to outstanding loans. Two main conclusions emerge. First, the behavior of either non-performing loans or interest margins is only weakly procyclical i.e., the solidity of Italian banks could be seriously undermined only in case of falls in output far more severe than in any previous recession since the end of the World War II. The preoccupation expressed by the literature about the dangers of financial procyclicality seems, therefore, grossly exaggerated in the case of Italy. Second, in a hypothetical scenario, where monetary conditions are drastically tightened our banks’ soundness indicators exhibit little variations. In this case too, the importance attached by the literature to exchange rate swings, or monetary tightening more generally, for the setting off of financial crises is vastly overstated.