Bank Stress Testing: Public Interest or Regulatory Capture?

Bank Stress Testing: Public Interest or Regulatory Capture?
Thomas Schneider, Philip E Strahan, Jun Yang
Review of Finance, Volume 27, Issue 2, March 2023, Pages 423–467,

Bank stress testing by the U.S. Federal Reserve (the Fed) is the most important innovation in bank capital regulation to have emerged after the 2008 Global Financial Crisis. In our recent paper, we investigate whether bank stress testing has been contaminated by capture of regulators by banks. Capture is plausible because the costs and benefits of stress testing are concentrated among the regulated, and the rules and implementation are both complex and opaque. Perhaps surprisingly, our results suggest that stress testing has furthered the public interest. However, we caution that recent changes to this regulatory framework may reduce the efficacy of bank stress testing and its ability to prevent a future financial crisis.

We provide unambiguous evidence that the large U.S. trading banks – those most likely deemed “Too Big to Fail” – face tougher stress tests than other banks across all dimensions. First, large trading banks’ portfolios decline much more under the Fed’s stress testing model than under the large trading banks’ own models, compared to other banks. The difference is large: almost 1.5 percentage points of risk-weighted assets. Second, large trading banks are more likely to fail stress tests, even after controlling fully for their quantitative stress test results.The higher rate of failure for the trading banks reflects greater regulatory scrutiny of internal risk-management practices and governance. Third, large trading banks make more conservative capital plans than other banks. Despite their more conservative capital plans, the large trading banks still fail their tests more frequently than other banks. Last, regulatory capital ratios increase for trading banks in the advent of the stress-testing regime, relative to other banks. We conclude that stress testing has served the public interest by forcing recapitalization of these most systematically important banks.

Also consistent with the public interest, we find no evidence that either political lobbying efforts or bank-regulatory connections affect leniency on the quantitative components of stress tests. We do find some evidence that banks with regulatory connections are less likely to fail the qualitative dimension of stress tests. We hesitate to over-emphasize this result, however, because the effects of connections are generally weak and insignificant in all our other tests.

As we move further from the Global Financial Crisis, public pressure for regulatory oversight has fallen. Banks and their advocates have complained about various aspects of stress testing, such as its opacity, and this advocacy has had an impact very recently. Changes have both relaxed constraints on bank capital distributions and reduced the information disclosed from the stress tests, potentially creating new opportunities for regulatory capture going forward.

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