Capital Market Consequences of EU Bank Stress Tests

Abstract

This paper examines the capital market consequences of government stress testing of banks in the European Union during the recent global financial crisis. Theory suggests that the announcement of forthcoming public disclosure and the eventual disclosure can induce changes in the information environment. Compared with propensity score matched control firms, I report that the announcement of stress tests generally elicited weak effects from measures of information asymmetry and information uncertainty for tested banks. I also report that after disclosure of 2011 test results, information asymmetry declined gradually but information uncertainty increased significantly. This suggests that while the revealed information enabled sorting of strong and weak banks, uncertainty worsened either due to low test credibility and unresolved bank capital plans, or due to negative signals about fundamentals. Furthermore, I document evidence that the unprecedented level of sovereign and total Exposure At Default disclosure in the 2011 test results had directional information content for measures of information asymmetry, information uncertainty, CDS spreads and equity returns. Collectively, the evidence highlights the importance of transparent and credible stress tests supported by a strong regulatory commitment to remedy negative outcomes.

Keywords: stress testing, financial crises, mandatory disclosure, information asymmetry, information uncertainty, information content

JEL Classification: G14, G28, M41