EU banks that were stress-tested reduced credit risk – ECB paper

Banks that were subject to 2016 stress tests reduced risk compared with control group, researchers find
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Banks subject to the 2016 European Union-wide stress tests significantly reduced their risk exposure, a working paper published by the European Central Bank (ECB) finds.

In The disciplining effect of supervisory scrutiny in the EU-wide stress test, Christoffer Kok et al. use supervisory data on a wide sample of banks, including a proportion that were not tested.

The authors look at EU banks’ balance sheets, profit-and-loss items and capital requirements between 2015 and 2017. The authors’ preferred measure of credit risk is “the aggregate risk-weight of banks’ entire credit risk exposures, called risk-weight density (RWD)”.

They compare the changes in EU banks that were subject to the ECB’s EU-wide stress test to those that were not. This approach, the authors argue, lets them disentangle the effects of stress test results being published from those caused by banks preparing for the tests.

The authors use two matching strategies to reduce the chance that specification criteria for banks slant the results. They exclude “all control banks that are smaller than the smallest tested bank and by excluding all tested banks that are larger than the biggest control group bank”. Their second strategy is to reduce the sample “by using only the two largest non-tested and two smallest tested banks within each country”.

The authors find banks that were stress-tested “reduced their average RWD by about 4.2 percentage points relative to banks that were not tested”. They find this effect to be economically significant.

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