Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights

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