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 high, the optimal stress test partially discloses information about banks' asset: it reduces the likelihood of bank runs. When the liquidation cost is low, the optimal stress test fully discloses information: it increases the likelihood of enjoying the high asset return. The central trade-off in the design of a stress test is between the bank run cost and the high asset return. The theory suggests regulatory policy coordination - joint design of the stress test and other policies that affect asset market liquidity.