The Reasons Why the 2011 Stress Tests Did Work
The 2011 supervisory stress test carried out by EBA on the European banking sector in the end turned out to provide investors with relevant information, mitigating the opacity that characterized the banking sector throughout the recent financial markets turmoil. This is perhaps the most striking result of Supervisors as Information Producers: Do Stress Tests Reduce Bank Opaqueness? (Journal of Banking and Finance, vol 37, issue 12, December 2013, pp. 5406-5420, doi: 10.1016/j.jbankfin.2013.01.005), an article by Andrea Resti (Department of Finance and Carefin) and Giovanni Petrella (Università Cattolica del Sacro Cuore).
Supervisory stress tests aim to assess the impact of a common adverse macroeconomic scenario on the profitability and capitalization of banks (usually large banks, accounting for a significant share of the overall loans and deposits). Existing research posits that the disclosure of stress tests results may be inherently flawed. Indeed, both their political nature and the fact that deep market downturns may not be reliably anticipated are likely to dent the supervisors' credibility, leading to an even higher market uncertainty when the stress test results are released. This is at odds with the very purpose of supervisory stress tests.
In their article the authors investigate the 2011 European stress test exercise to assess whether and how it affected bank stock prices, testing the hypothesis that stress tests don't produce relevant information for market participants (''irrelevance hypothesis''). They end up confirming that market prices significantly reacted upon disclosure of the results. This implies that stress tests revealed new information to the stock market, which affected the investors' trading behavior, rejecting the irrelevance hypothesis. Additionally, the abnormal returns of tested banks are strongly related to some stress test outputs, such as several ratios expressing the banks' vulnerability to potential downturn scenarios. Deepening the empirical analysis the authors also show that positive market reaction is likely to be caused by the more granular historical information provided by the European Banking Authority as a result of the stress tests (''zoom hypothesis''), as well as by the resiliency indicators generated by the stress test exercise (''stress hypothesis'').
In their sample of 96 banks across the European Union (covering a large fraction of the European banking industry by market cap), Resti and Petrella point out a striking difference between the performances (measured as the cumulative abnormal returns both pre-results and upon results releases of the bank-by-bank stress tests) of the banks which successfully went through the stress tests and those which have not been tested by the European Banking Authority. This finding corroborates the informational role of stress tests and support the authors' conclusion that banks supervision may mitigate bank opaqueness.
The information content of stress tests has several important policy implications. As a matter of fact, the effectiveness of the information disclosure is at the core of the supervisors' decision to disclose simulation results. If, for instance, the zoom hypothesis prevails and the stress hypothesis is rejected there is no reason to release the simulation results to the market. Supervisors should by contrast deliver the stress tests results on a confidential basis. As such, downturn scenarios and their implications should only be discussed bilaterally between bankers and supervisors. On the other hand, if the zoom hypothesis is rejected and the stress hypothesis prevails, the effort made by the supervisors is mostly perceived as useless or unreliable. The fact that the authors cannot reject both the zoom and stress hypothesis, proves that supervisory stress tests convey information to the market participants which goes beyond simple bank-specific accounting information.