The Coordination Role of Stress Tests in Bank Risk-Taking

Carlos Corona, Lin Nan, Gaoqing Zhang

Research output: Contribution to journalArticlepeer-review

Abstract

We examine whether stress tests distort banks' risk-taking decisions. We study a model in which a regulator may choose to rescue banks in the event of concurrent bank failures. Our analysis reveals a novel coordination role of stress tests. Disclosure of stress-test results informs banks of the failure likelihood of other banks, which can reduce welfare by facilitating banks' coordination in risk-taking. However, conducting stress tests also enables the regulator to more effectively intervene banks, coordinating them preemptively into taking lower risks. We find that, if the regulator has a strong incentive to bail out, stress tests improve welfare, whereas if the regulator's incentive to bail out is weak, stress tests impair welfare.

Original languageEnglish (US)
Pages (from-to)1161-1200
Number of pages40
JournalJournal of Accounting Research
Volume57
Issue number5
DOIs
StatePublished - Dec 1 2019

Keywords

  • G01
  • G21
  • G28
  • M40
  • M41
  • bailout
  • bank regulation
  • bank risk-taking
  • coordination
  • stress test
  • stress-test disclosure

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