Optimal Stress Tests and Liquidation Cost

Abstract

We study stress tests as Bayesian persuasion within the fundamental bank run framework. This paper shows that the optimal disclosure policy depends on the liquidation cost of the long-term asset. In particular, when the liquidation cost is low, the optimal stress test fully discloses information about banks: it increases the likelihood of enjoying the high asset return. When the liquidation cost is high, the optimal stress test partially discloses information: it reduces the likelihood of costly bank runs. The central trade-off in stress test design is between the bank run cost and the high asset return. The theory suggests regulatory policy coordination and offers insights on different stress testing experiences across countries.

Keywords: Banking, Stress Test, Bayesian Persuasion, Information Design, Liquidation Cost

JEL Classification: D83, D84, G21, G28