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Limits of stress-test based bank regulation

Tirupam Goel and Isha Agarwal

No 953, BIS Working Papers from Bank for International Settlements

Abstract: Supervisory risk assessment tools, such as stress-tests, provide complementary information about bank-specific risk exposures. Recent empirical evidence, however, underscores the potential inaccuracies inherent in such assessments. We develop a model to investigate the regulatory implications of these inaccuracies. In the absence of such tools, the regulator sets the same requirement across banks. Risk assessment tools provide a noisy signal about banks' types, and enable bank specific capital surcharges, which can improve welfare. Yet, a noisy assessment can distort banks' ex ante incentives and lead to riskier banks. The optimal surcharge is zero when assessment accuracy is below a certain threshold, and increases with accuracy otherwise.

Keywords: capital regulation; stress-tests; information asymmetry; adverse incentives; disclosure policy; Covid-19 (search for similar items in EconPapers)
JEL-codes: C61 G21 G28 (search for similar items in EconPapers)
Pages: 56 pages
Date: 2021-07
New Economics Papers: this item is included in nep-ban, nep-cba and nep-rmg
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