Bank stress tests: How much do we need to know?

By Francine McKenna     
June 17, 2014

From: Magazine

Photo via Shutterstock.

The US Federal Reserve Bank conducts two annual stress tests of large bank holding companies (BHCs) and nonbank financial companies as part of the changes introduced by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The first test uses quantitative measures to judge whether BHCs have enough capital to absorb losses caused by stressful economic and financial market conditions. The second, more qualitative test ensures that institutions have robust, forward-looking capital-planning processes to get them through tough times. 

The new stress tests aim to give regulators more information, which might add them to intervene appropriately to recapitalize weak or insolvent banks. However, Chicago Booth Professor Haresh Sapra and the University of Pennsylvania's Itay Goldstein caution that while the tests are valuable, regulators should be careful about how much information they disclose about individual institutions. 

When Congress mandated stress tests, it required the Fed to disclose the results, but left to regulators’ discretion the level of detail to be disclosed. Full disclosure—detailing how each BHC could perform in a variety of scenarios—could result in greater overall financial stability, but at a price to individual banks. These consequences need to be weighed carefully, say the researchers. 

One positive effect is that full disclosure could inhibit excessive risk-taking. “Public disclosure of a bank’s financial condition enables market participants to make informed decisions about the bank and such informed decisions, in turn, discipline the bank’s actions,” write Sapra and Goldstein.

But while the goal of overall financial stability may be well served by disclosing stress-test results, bank-specific disclosures may encourage suboptimal balance-sheet behavior, the researchers explain. For example, banks could try to “game” the process with weak portfolios or balance-sheet window dressing that allows them to pass a test but reduces long-term shareholder value. 

Banks have argued against full disclosure because it generates proprietary costs—information about the bank’s portfolio and its vulnerabilities may leak to competing firms. Banks that expect individual results to be disclosed may also be less frank with regulators.

In the end, stress tests have two implied goals that may be incompatible, the researchers say. The microprudential goal is to help regulators be sure an individual bank has sufficient capital to absorb potential losses and remain solvent. The macroprudential goal is to reassure regulators the banking sector can survive a systemic crisis. Macroprudential success means overall financial stability may be achieved but the survival of any particular bank is not necessarily assured. 

Sapra and Goldstein make several recommendations to mitigate potential unintended consequences of bank-by-bank disclosures. They recommend the Fed keep secret actual test models so that banks don’t “study to the test.” They say test disclosures should include detailed information about the risk exposures of each bank by asset class, country, and the assets’ level of maturity, so the market can evaluate whether a bank “cheated” to pass the test.

The Fed’s ultimate decision about stress-test disclosure requires prioritizing its macroprudential and microprudential goals.

Work cited

Haresh Sapra and Itay Goldstein, "Should Banks' Stress Test Results Be Disclosed? An Analysis of the Costs and Benefits," Foundations and Trends in Finance, forthcoming.