The informational value of bank stress tests
In this paper Guerrieri and Modugno examine different types of information market participants deduce from the release of the results of bank stress test. In the U.S. through 2019, results for two distinct phases of the stress tests were announced one week apart, with the results of the Dodd Frank Act Stress Tests (DFAST) coming before the results for the Comprehensive Capital Analysis and Review (CCAR). The DFAST results bore no direct supervisory consequences for the firms, while the Federal Reserve could curb capital distributions based on the subsequent CCAR results. They find that:
- Upon the release of the DFAST results which show increases in loss absorption capacity, CDS spreads declined and stock prices increased. These reactions indicate that market participants interpret the DFAST results as indicative of greater resilience;
- On the other hand, the release of CCAR results triggered a reaction in stock prices that was systematically related to actions undertaken by the Federal Reserve that curbed capital distributions. For example, when capital plans were objected to or not approved, stock prices declined.
These results back the widespread use of stress tests to inform market participants on the soundness of banks. Our analysis shows that market participants value the stress test announcements not only to gauge future capital distributions, which would simply benefit a limited set of investors, but also as indicators of bank resilience, with importance for the broader public.
The Information Content of Stress Test Announcements
Authors: Luca Guerrieri, Michele Modugno
From: Board of Governors of the Federal Reserve System
The Fed’s recent bank tests did not examine the impact of higher interest rates!
The Fed has been repeating a broadly similar scenario each year for the stress tests, argues Patrick Honohan.
Only in interest rates is the pattern of stress different from year to year. But even here, the differences have a common cause, namely that, no matter where it begins, the 3-month Treasury bill rate is assumed every year in the severely adverse case to fall to just above zero. It’s effectively the same stress. […] No wonder the vulnerability of the business model of some banks has flown under the supervisory system’s radar.
The Fed’s recent bank stress tests used scenarios with little variation. None examined higher interest rates
By: Patrick Honohan – Peterson Institute for International Economics
