Should Banks’ Stress Test Results be Disclosed? An Analysis of the Costs and Benefits

Abstract

Stress tests have become an important component of the supervisory toolkit. However, the extent of disclosure of stress-test results remains controversial. We argue that while stress tests uncover unique information to outsiders — because banks operate in second--best environments with multiple imperfections — there are potential endogenous costs associated with such disclosure. First, disclosure might interfere with the operation of the interbank market and the risk sharing provided in this market. Second, while disclosure might improve price efficiency and hence market discipline, it might also induce sub-optimal behavior in banks. Third, disclosure might induce ex post market externalities that lead to excessive and inefficient reaction to public news. Fourth, disclosure might also reduce traders’ incentives to gather information, which reduces market discipline because it hampers the ability of supervisors to learn from market data for their regulatory actions. Overall, we believe that disclosure of stress-test results is beneficial because it promotes financial stability. However, in promoting financial stability, such disclosures may exacerbate bank-specific inefficiencies. We provide some guidance on how such inefficiencies could be minimized.