Aggregate Shocks, Loan Losses, and Portfolio Concentrations: Lessons for Assessing Depository Institution Risk

The enormous problems facing the banking and thrift industries have concentrated attention on regulatory redesign, but these recent deliberations have not given sufficient attention to the sensitivity of depository institution risk to aggregate (or macroeconomic) shocks. This study offers a quantitative examination of aggregate shocks that impact depository institution risk in two ways. First, aggregate shocks create covariation between assets held in the portfolio. Our results demonstrate that this covariation is of first-order importance; when covariation is ignored, risk-exposure can be underestimated by 70% to 800%. Second, aggregate shocks will have a direct effect on the economy, and hence on depository institution performance. Based on our empirical evidence, we conclude that current initiatives and deliberations must be more sensitive to the effects of aggregate shocks on depository institutions laid vulnerable by past policy mistakes. Piecemeal approaches to regulatory reform that fail to recognize these interrelationships will ultimately prove inadequate to the tasks of identifying and controlling risk.