Limits of stress-test based bank regulation - BIS Working Papers No 953 - July 2021

Summary

Focus
How should supervisory risk assessments, such as stress tests, inform bank regulation when such assessments provide imprecise signals? What trade-offs do regulators face when redesigning assessments to improve accuracy? Does the disclosure of assessment results improve the effectiveness of capital requirements? We develop a theoretical framework to investigate these questions. A key element of our framework is the impact of assessment accuracy on the future behaviour of banks. This, in turn, is crucial for the design of risk assessments and for subsequent decision-making about capital requirements.

Contribution
This paper strives to fill an apparent gap in the literature. Despite empirical evidence of noisy risk assessments, there is a lack of studies on what this noise implies for the effectiveness of capital requirements. We examine how capital regulation based on potentially inaccurate assessments affects banks' incentives to improve their risk profile, and derive the attendant optimal regulation. Our framework is robust and tractable. This also allows us to study trade-offs faced by regulators when making assessments more accurate and in disclosing results to investors. Moreover, we examine trade-offs involved in choosing optimal capital requirements when bank failure is socially costly.

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