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
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