Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights

48 Pages Posted: 16 Apr 2013

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Robert F. Engle

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER); New York University (NYU) - Volatility and Risk Institute

Diane Pierret

Universite du Luxembourg - Luxembourg School of Finance; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 4 versions of this paper

Date Written: April 2013

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 rather low, and 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 Classification: G01, G11, G21, G28

Suggested Citation

Acharya, Viral V. and Acharya, Viral V. and Engle, Robert F. and Pierret, Diane, Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights (April 2013). CEPR Discussion Paper No. DP9431, Available at SSRN: https://ssrn.com/abstract=2251711

Viral V. Acharya (Contact Author)

New York University (NYU) - Leonard N. Stern School of Business ( email )

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HOME PAGE: http://www.stern.nyu.edu/~vacharya

New York University (NYU) - Department of Finance ( email )

Stern School of Business
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Centre for Economic Policy Research (CEPR) ( email )

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National Bureau of Economic Research (NBER) ( email )

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Robert F. Engle

New York University (NYU) - Department of Finance ( email )

Stern School of Business
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New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

New York University (NYU) - Volatility and Risk Institute ( email )

44 West 4th Street
New York, NY 10012
United States

Diane Pierret

Universite du Luxembourg - Luxembourg School of Finance ( email )

162a, avenue de la Faïencerie
Luxembourg-Limpertsberg, L-1511
Luxembourg

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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