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Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights

51 Pages Posted: 4 Apr 2013 Last revised: 1 Oct 2015

Viral V. Acharya

New York University - Leonard N. Stern School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); New York University (NYU) - Department of Finance

Robert F. Engle

New York University - Leonard N. Stern School of Business - Department of Economics; New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Diane Pierret

HEC - University of Lausanne; Swiss Finance Institute

Multiple version iconThere are 4 versions of this paper

Date Written: March 31, 2014

Abstract

Macroprudential stress tests have been employed by regulators in the United States and Europe to assess and address the solvency condition of financial firms in adverse macroeconomic scenarios. Financial institutions are required to maintain a capital cushion against such events and stress tests are designed to assess if it is adequate. If it is not, then the capital shortfall is the additional capital needed. We compare the capital shortfall measured by regulatory stress tests, to that of a benchmark methodology — the “V-Lab stress test” — that employs only publicly available market data. We find that when capital shortfalls are measured relative to risk-weighted assets, the ranking of financial institutions is very different from the V-Lab stress test, whereas when measured relative to total assets, the results are quite similar. We show that the risk measures used in risk-weighted assets are cross-sectionally uncorrelated with market measures of risk as they do not account for the “risk that risk will change.” Furthermore, the firms that appeared to be best capitalized relative to risk-weighted assets were no better than the rest when the European economy deteriorated into the sovereign debt crisis in 2011.

Keywords: macroprudential regulation, stress test, systemic risk, risk-weighted assets

JEL Classification: G28, G21, G11, G01

Suggested Citation

Acharya, Viral V. and Engle, Robert F. and Pierret, Diane, Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights (March 31, 2014). Available at SSRN: https://ssrn.com/abstract=2245211 or http://dx.doi.org/10.2139/ssrn.2245211

Viral Acharya

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Robert Engle

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Diane Pierret (Contact Author)

HEC - University of Lausanne ( email )

Institute of Banking and Finance
Unil Dorigny, Batiment Extranef
Lausanne, 1015
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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