Do bank stress tests reduce the reliance on credit rating downgrades?

Abstract

Applying event study methodology on the US stock market, we present evidence that investors rely more on credit ratings for banks relative to non-financials and attribute this to a higher level of opacity. This effect is even reinforced during the financial crisis as bank opacity generally increases during stress periods. In response to the crisis, stress tests were introduced by the Federal Reserve in 2009 to alleviate the negative effects of bank opacity. We show that the stress tests have reduced the reliance on rating downgrades for stress-tested banks, and hence conclude that the tests succeeded to reduce bank opacity. However, we also find that the effect starts to decrease 6 months after the stress test disclosure. Moreover, stress tests do not affect the reliance on credit ratings for non-stress-tested banks, indicating that stress tests do not resolve potential negative effects of bank opacity for non-stress-tested banks. Our results suggest that policy makers should consider increasing the frequency of stress tests and extending the sample of stress-tested banks.