March Madness In Wall Street: (What) Does The Market Learn From Stress Tests?

Marcelo Fernandes

Queen Mary University of London – Economics Department

Deniz Igan

International Monetary Fund (IMF) – Financial Studies Division

Marcelo Pinheiro

PCAOB

December 2015

IMF Working Paper No. 15/271

Abstract:

Annual stress tests have become a regular part of the supervisors’ toolkit following the global financial crisis. We investigate their capital market implications in the United States by looking at price and trade reactions, information asymmetry and uncertainty indicators, and bank activities. The evidence we present supports the notion that there is important new information in stress tests, especially at times of financial distress. Moreover, public disclosure seems to help reduce informational asymmetries. Importantly, public disclosure of stress test results (and methodology) does not seem to have reduced private incentives to generate information or to have led to distorted incentives.

March Madness In Wall Street: (What) Does The Market Learn From Stress Tests? – Introduction

Ever since the financial crisis of 2008–09 threatened to bring down the entire U.S. economy with repercussions for the global economy, policymakers and regulators have been looking for ways to enhance the supervisory frameworks to prevent a repeat. In the United States, these efforts mostly culminated in passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act. But even before the passage of the Act regulators have separately been focused on honing the tools they have to ensure that banks can survive adverse, even disastrous, economic and financial conditions in what have now become known as “stress tests.”

The jury is, however, still out when it comes to whether the stress tests have made the financial system safer. Opponents have argued that there was no useful information in the stress tests and the tests could actually be harmful as they create a false sense of security (see, for instance, Dowd, 2015). Of particular concern has been the possible effect of stress tests on capital markets and various agents’ incentives. On the one hand, public disclosure of the supervisors’ information subset may improve price efficiency and enhance market and supervisory discipline. On the other hand, private incentives to generate information may be diluted and risk-sharing opportunities may decrease. Moreover, banks may resort to accounting gimmicks and model convergence to anticipate and deliver on the supervisors’ expectations. At the end, price informativeness may worsen and uncertainty may increase, leading to excessive volatility and a more vulnerable system.

In this paper, we examine the capital market implications of stress tests in the United States since the onset of the global financial crisis. A general objective of financial regulation is to reduce information asymmetry by mandating periodic disclosures to investors. In the midst of the global financial crisis, the demand for accurate information on the financial condition of the banks surged. The answer to this demand during the crisis came through the stress tests, which evaluated the impact of adverse scenarios on bank soundness and have become a mainstay of supervision. We ask whether and how capital markets react to the information revealed by the stress tests as well as if and how disclosure of these tests affects information generation and processing in capital markets. In particular, we analyze equity and bond price changes and jumps, equity and credit bid-ask spreads, implied volatilities, and CDS spreads in a difference-in-difference event-study setup to tease out the effects of stress test announcement and results disclosure.

Stress Tests

The evidence we present indicates that there is important information in stress tests, especially at times of stress. Markets tend to react to stress test announcements, with the direction of the price reaction dependent on the nature of the news (e.g., whether the scenarios depict more or less stressful conditions than the markets foresee or whether a bank has failed or passed the quantitative thresholds). Higher moments of the distribution are also affected and trading activity picks up. Interestingly, the reaction is not limited to the tested banks only, affecting as well banks that are not subject to the tests. This suggests that stress tests reveal information about systemic risk (or the supervisor’s perception thereof), which by definition is relevant for all banks. While the reaction seems to get weaker as stress tests become more established and the announcement dates more or less known, there appears to be still some information contained in the scenarios released from one year to the next and the supervisors’ assessment of the banks’ health. There is some indication that information asymmetry increases with announcements, though it then declines after the release of the results. Information uncertainty does not appear to be affected significantly, suggesting that markets may believe that the public disclosure contains useful information but continue to produce private information rather than simply rely on the information that supervisors make publicly available.

Stress Tests

All in all, there is new information in stress tests and public disclosure helps reduce informational asymmetries and uncertainties, especially when markets are under distress. Moreover, public disclosure of stress test results (and methodology) does not seem to have reduced private incentives to generate information.

These findings have important policy implications. Borio et al. (2013) argue that macro stress tests are ill suited as early warning devices but they can be effective as crisis management and resolution tools. The finding that banks passing stress tests enjoy positive abnormal returns during times of heightened overall stress in the economy suggests that the market perceives stress tests in a similar way. Also supportive of this interpretation is the finding that the market learns new information about untested banks as well.

Stress Tests

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