Stress Test Failures and Corporate Mergers and Acquisitions

Abstract

This study documents that corporate borrowers of banks that failed stress tests subsequently conduct fewer mergers and acquisitions (M&A). The effect is stronger for treated firms with weaker corporate governance or more susceptible to managerial agency problems. We further document increased financial covenant usage in M&A-related bank loan contracts, as well as improved M&A deal quality, after stress test failures, suggesting that stress testing failures triggered enhanced bank screening on borrowers’ M&A projects. Moreover, refrained from M&A activity that can hurt shareholders, treated firms subsequently improve their profitability. Our empirical evidence highlights a beneficial spillover effects of bank stress tests.