The Coordination Role of Stress Tests in Bank Risk Taking
58 Pages Posted: 5 Jul 2018 Last revised: 9 Oct 2019
Date Written: October 9, 2019
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: Suggested Citation