Design of Macro-Prudential Stress Tests

220 Pages Posted: 1 Jun 2017 Last revised: 6 Nov 2021

See all articles by Dmitry Orlov

Dmitry Orlov

University of Wisconsin School of Business

Pavel Zryumov

University of Rochester - Simon Business School

Andrzej Skrzypacz

Stanford University - Stanford Graduate School of Business

Date Written: November 5, 2021

Abstract

We study the design of stress tests that provide information about aggregate and idiosyncratic risk in banks’ portfolios and impose contingent capital requirements. In the optimal static test, an adverse scenario fails all weak and some strong banks, limiting the stigma of failure. Sequential tests outperform static tests. Under natural conditions, the optimal sequential test consists of a precautionary recapitalization followed by a scenario that fails only weak banks, similar to TARP in 2008 followed by SCAP in 2009. Our results also shed light on the Federal Reserve’s decision to test the banks twice in 2020 during the Covid-19 pandemic.

Keywords: Stress Tests, Capital Requirements, Systemic Risk, Macro-Prudential Regulation, Mechanism Design, Dynamic mechanisms, Bayesian Persuasion.

JEL Classification: G01, G28, D61, D83

Suggested Citation

Orlov, Dmitry and Zryumov, Pavel and Skrzypacz, Andrzej, Design of Macro-Prudential Stress Tests (November 5, 2021). Simon Business School Working Paper No. FR 17-14, Stanford University Graduate School of Business Research Paper No. 17-41, Available at SSRN: https://ssrn.com/abstract=2977016 or http://dx.doi.org/10.2139/ssrn.2977016

Dmitry Orlov (Contact Author)

University of Wisconsin School of Business ( email )

975 University Avenue
Madison, WI 53706
United States

HOME PAGE: http://https://wsb.wisc.edu/directory/faculty/dmitry-orlov

Pavel Zryumov

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

Andrzej Skrzypacz

Stanford University - Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States
650-736-0987 (Phone)
650-725-9932 (Fax)

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