[Link to paper] 

Abstract: Stress tests are conducted frequently, and they disclose valuable information about the bank. A credible stress test design must account for stakeholders’ strategic responses to the test results and ensure that any bank passing a test will not fail thereafter. We build a dynamic coordination framework to study the optimal design of credible stress tests. We show that higher testing frequency reduces the need for greater stringency of tests to make it credible. We also find the optimal stress test policy and show how it depends on macroeconomic conditions, the bank’s systemic importance, distortionary private incentives, administrative costs, and the liability structure.

Presentation (by one of the authors): 7th Bristol Workshop on Banking and Financial Intermediation, Bank of England Financial Stability Seminar, Chinese Finance Research Conference (CFRC), Econometric Society meetings, Fudan Workshop on Economic Dynamics, Stony Brook Game Theory meetings,

Kelley School of Business, and SWUFE