Why Don't Stress Tests Break Banks?
28 Pages Posted: 1 Jun 2016
Date Written: May 31, 2016
Abstract
Despite continued advances in the state of the art, stress tests predict failure less often than would seem reasonable. This paper argues that even if a stress test produces a good estimate for aggregate losses, failing to account for unevenness of losses could easily lead to an under-estimate of likely failures. Instead of relying on mean estimates for residential loan portfolio default rate, LVR and underlying property values, this paper uses distributional properties, providing a more realistic setting by allowing for variation between banks. A key finding is that once such variation is included, the increase in average banking system losses is substantial. Both the average bank and the worst performing group of banks suffer a significantly greater magnitude of loss. A simple intensification algorithm is then presented which allows for stress tests to generate more insight into the likelihood of failure for a given population under stress. The intensification outcomes may well generate a better specified stress model, as the failure patterns brought to light by intensification may reveal better ways to differentiate the stressed population.
Keywords: Commercial banks, Bank regulation, Stress testing, Capital Management, Residential mortgage
JEL Classification: G21, G28
Suggested Citation: Suggested Citation