Time Inconsistency in Stress Test Design

Abstract

We show that central banks face a time inconsistency problem when publishing bank stress test results. Before a stress test, they want to appear tough as the threat of letting banks fail the stress test incentivizes prudent behaviour. After the stress test, they want to act soft by releasing only partial information in order to reassure financial markets about bank health. We characterize an institutional design solution to this commitment problem: a social planner sets the framework within which the central bank communicates. We find that a hurdle rate framework, where all banks are judged to pass or fail relative to a common threshold, is optimal in many settings as it generates intermediate levels of both incentives and reassurance. With a hurdle rate framework, stress tests become an informational contagion channel, as changes in the health of one bank affect beliefs about the health of other banks. Thus, informational contagion can be a feature of a socially optimal institutional design in the presence of a time inconsistency problem.