The Unintended Consequences of Bank Stress Tests

Abstract

Stress tests are assessments conducted by regulators to determine whether banks have sufficient capital buffers to withstand severe recessions. Unlike ordinary bank examinations, stress tests involve forward-looking scenarios and their results are publicly disclosed. This paper is the first study to show the consequences of bank stress tests. My estimates indicate that there is a negative causal impact of capital adequacy requirements on managerial decisions in the U.S. banking system. Managers make real decisions regarding restructuring problematic loans or removing them completely from their books. Stress-tested banks reduce net loan charge-offs and keep problematic loans on their books to a greater extent than banks in a non-tested group to meet the capital ratio requirements. Managers increase the level of non-performing loans in the aftermath of stress tests announcement. Stress-tested banks with greater exposure to the housing market change the classification of loan losses to a greater extent than other banks. The study’s results remain robust using mid-sized banks that have been subject to the latest rounds of stress tests.