DP12624 Modeling Your Stress Away

Author(s): Friederike Niepmann, Viktors Stebunovs
Publication Date: January 2018
Date Revised: July 2018
Keyword(s): credit risk models, financial institutions, regulation, stress tests
JEL(s): G21, G28
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12624

We investigate systematic changes in banks? projected credit losses between the 2014 and 2016 EBA stress tests, employing methodology from Philippon et al. (2017). We find that projected credit losses were smoothed across the tests through systematic model adjustments. Those banks whose losses would have increased the most from 2014 to 2016 due to changes in the supervisory scenarios - keeping the models constant - saw the largest decrease in losses due to model changes. Model changes were more pronounced for banks that rely more on the Internal Ratings-Based approach, and they explain the cross-section of market responses to the release of the 2016 results. Stock prices and CDS spreads increased more for banks with larger reductions in projected credit losses due to model changes, as investors apparently did not interpret lower loan losses as reflecting mainly a decrease in credit risk but, instead, as a sign of lower capital requirements going forward.