DP13907 Stress Testing and Bank Lending

Author(s): Joel Shapiro, Jing Zeng
Publication Date: August 2019
Keyword(s): bank lending, Bank Regulation, reputation, stress tests
JEL(s): G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13907

Bank stress tests are a major form of regulatory oversight. Banks respond to the toughness of the tests by changing their lending behavior. Regulators care about bank lending; therefore, banks' reactions to the tests affect the tests' design and create a feedback loop. We demonstrate that stress tests may be (1) soft, in order to encourage lending in the future, or (2) tough, in order to deter excessive risk-taking in the future. There may be multiple equilibria due to strategic complementarity. Regulators may strategically delay stress tests. We also analyze bottom-up stress tests and banking supervision exams.