Stress Testing and Bank Lending

Abstract

Stress tests can affect banks' lending behavior. Regulators must take banks' reactions into account: this can lead to soft stress tests in which a risky bank is passed in order to encourage lending, or to tough stress tests in which a safe bank is failed in order to reduce future risk taking. These short-term actions by the regulator can lead to long-term gains. However, information management can lead to inefficiencies when (i) banks react ex-ante to the anticipated stress test regime; (ii) the test loses credibility; or (iii) the test becomes self-fulfilling. When banks are more systemic, stress tests become tougher.

Keywords: Bank regulation, stress tests, bank lending, reputation

JEL Classification: G21, G28