Modeling your stress away

Abstract

This paper investigates the validity of banks' credit loss projections in the bi-annual EU-wide bank stress tests, which inform regulatory capital requirements. It finds that banks “re-optimized” their models in 2016 to bring down credit losses, exploiting flexibility in the stress test framework. Specifically, banks whose losses would have increased the most from 2014 to 2016 because of changes in the adverse scenario saw the largest decrease in projected losses thanks to model changes. Upon the release of the 2016 stress test results, stock prices and credit default swap spreads increased more for banks that achieved a greater reduction in credit losses through “re-optimization”, consistent with investors anticipating lower future capital requirements for these banks.