Working Paper: CEPR ID: DP9800
Authors: Viral Acharya; Robert Engle; Diane Pierret
Abstract: Macroprudential stress tests have been employed by regulators in the United States and Europe to assess and address the solvency condition of financial firms in adverse macroeconomic scenarios. We provide a test of these stress tests by comparing their risk assessments and outcomes to those from a simple methodology that relies on publicly available market data and forecasts the capital shortfall of financial firms in severe market-wide downturns. We find that: (i) The losses projected on financial firm balance-sheets compare well between actual stress tests and the market-data based assessments, and both relate well to actual realized losses in case of future stress to the economy; (ii) In striking contrast, the required capitalization of financial firms in stress tests is found to be inadequate ex post compared to that implied by market data; (iii) This discrepancy arises due to the reliance on regulatory risk weights in determining required levels of capital once stress-test losses are taken into account. In particular, the continued reliance on regulatory risk weights in stress tests appears to have left financial sectors under-capitalized, especially during the European sovereign debt crisis, and likely also provided perverse incentives to build up exposures to low risk-weight assets.
Keywords: macroprudential regulation; risk-weighted assets; stress test; systemic risk
JEL Codes: G01; G11; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| regulatory risk weights (G28) | inadequacy of capital requirements (G28) |
| projected losses from stress tests (G28) | actual realized losses (G33) |
| required capitalization of financial firms (G28) | capital shortfalls implied by market data (E44) |
| stress tests relying on regulatory risk weights (G28) | misallocation of capital across banks (G21) |