Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights

Robert Engle, Viral Acharya and Diane Pierret

No 9800, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Macroprudential stress tests have been employed by regulators in the United States and Europe to assess and address the solvency condition of financial firms in adverse macroeconomic scenarios. We provide a test of these stress tests by comparing their risk assessments and outcomes to those from a simple methodology that relies on publicly available market data and forecasts the capital shortfall of financial firms in severe market-wide downturns. We find that: (i) The losses projected on financial firm balance-sheets compare well between actual stress tests and the market-data based assessments, and both relate well to actual realized losses in case of future stress to the economy; (ii) In striking contrast, the required capitalization of financial firms in stress tests is found to be inadequate ex post compared to that implied by market data; (iii) This discrepancy arises due to the reliance on regulatory risk weights in determining required levels of capital once stress-test losses are taken into account. In particular, the continued reliance on regulatory risk weights in stress tests appears to have left financial sectors under-capitalized, especially during the European sovereign debt crisis, and likely also provided perverse incentives to build up exposures to low risk-weight assets.

Keywords: Macroprudential regulation; Stress test; Systemic risk; Risk-weighted assets (search for similar items in EconPapers)
JEL-codes: G01 G11 G21 G28 (search for similar items in EconPapers)
Date: 2014-01
New Economics Papers: this item is included in nep-ban, nep-cba, nep-reg and nep-rmg
References: Add references at CitEc
Citations: View citations in EconPapers (160)

Downloads: (external link)
https://cepr.org/publications/DP9800 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Journal Article: Testing macroprudential stress tests: The risk of regulatory risk weights (2014)
Working Paper: Testing macroprudential stress tests: The risk of regulatory risk weights (2014)
Working Paper: Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights (2013)
Working Paper: Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights (2013)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:9800

Ordering information: This working paper can be ordered from
https://cepr.org/publications/DP9800

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().