Do macro-financial conditions amplify shocks in banking system vulnerability?

Can macro-financial conditions amplify adverse shocks originating in the banking system? We argue that when vulnerability in the banking system increases, the extent to which financial intermediation and the macroeconomy are adversely affected is likely to depend on whether banks are operating in normal times or under more challenging conditions. Using a Bayesian Panel Threshold VAR, data on euro area countries and a high-frequency, forward-looking measure of the banking system’s vulnerability to market-based equity losses, we show that nonlinearities matter. When the banking system is already in distress, lending and economic activity contract more severely following a further increase in banks’ vulnerability. Similarly, low interest rates, typically associated with low bank margins and profitability, correspond to larger declines in lending. In both environments, corporate lending contracts more than mortgage lending, a finding consistent with de-risking. The state of the business cycle, though, does not alter shock propagation to the same extent. Our findings suggest that it is particularly important for macroprudential policies to preserve banks’ resilience in times of stress, characterized by elevated banking system vulnerability and low interest rates.