Optimal Severity of Stress Test Scenarios

70 Pages Posted: 1 Nov 2024 Last revised: 4 Nov 2024

Date Written: October 29, 2024

Abstract

Regularly conducted stress tests constitute a constraint on bank balance sheets: future equity must suffice to maintain current lending even after absorbing severe losses. Studying such a forward looking constraint in a representative bank model, we show that a stricter stress test scenario leads to lower dividends, higher equity buffers, and lower, albeit less volatile, lending. Given this trade-off, the optimal scenario implies capital buffers of up to 6% when facing loan returns similar to those of large U.S. banks. Finally, we show that complementing stress tests with dividend restrictions improves lending stability, while relaxing counter-cyclical capital buffers does not.

Keywords: Bank Stress Tests, Forward-Looking Equity Constraints, Optimal Lending, Complimentary of Regulations

Suggested Citation

Fischer, Johannes J. and Kessler, Natalie, Optimal Severity of Stress Test Scenarios (October 29, 2024). Robert Schuman Centre for Advanced Studies Research Paper No. 2024/52, Available at SSRN: https://ssrn.com/abstract=5005782 or http://dx.doi.org/10.2139/ssrn.5005782

Johannes J. Fischer (Contact Author)

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Natalie Kessler

Independent ( email )

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