Stress test precision and bank competition

Abstract

We study a banking sector in which banks choose their asset portfolios and, upon the public disclosure of stress test results, raise funding by promising investors a repayment. Competitive banks must gamble, choosing assets that are riskier the more precise is the stress test. Allocative efficiency, however, improves with precision. When risk taking is not too sensitive to the precision of information, maximal transparency maximizes both stability and surplus. In contrast, banks with market power select safer assets, and opacity maximizes stability, as well the surplus if the social cost of bank failure is significant.