The Coordination Role of Stress Tests in Bank Risk Taking

58 Pages Posted: 5 Jul 2018 Last revised: 9 Oct 2019

See all articles by Carlos Corona

Carlos Corona

Carnegie Mellon University - David A. Tepper School of Business

Lin Nan

Purdue University

Gaoqing Zhang

University of Minnesota

Date Written: October 9, 2019

Abstract

We examine whether stress tests distort banks' risk-taking decisions. We study a model in which a regulator may choose to rescue banks in the event of concurrent bank failures. Our analysis reveals a novel coordination role of stress tests. Disclosure of stress-test results informs banks of the failure likelihood of other banks, which can reduce welfare by facilitating banks' coordination in risk-taking. However, conducting stress tests also enables the regulator to more effectively intervene banks, coordinating them preemptively into taking lower risks. We find that, if the regulator has a strong incentive to bail out, stress tests improve welfare, whereas if the regulator's incentive to bail out is weak, stress tests impair welfare.

Keywords: Stress test, Stress-test disclosure, Bank regulation, Bank risk-taking, Bailout, Coordination

JEL Classification: G01, G21, G28, M40, M41

Suggested Citation

Corona, Carlos and Nan, Lin and Zhang, Gaoqing, The Coordination Role of Stress Tests in Bank Risk Taking (October 9, 2019). Available at SSRN: https://ssrn.com/abstract=3201973 or http://dx.doi.org/10.2139/ssrn.3201973

Carlos Corona

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

Lin Nan

Purdue University ( email )

100 S Grant St
West Lafayette, IN 47907
United States
7654960551 (Phone)

Gaoqing Zhang (Contact Author)

University of Minnesota ( email )

321 19th Avenue South
Minneapolis, MN 55455
United States

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