The Impact of Regulatory Stress Testing on Bank's Equity and CDS Performance

Abstract

This paper investigates the impact of stress testing results on bank's equity and CDS performance using a large sample of ten tests from the US CCAR and the European EBA regimes in the time period between 2010 and 2017. We find that passing banks experience positive abnormal equity returns and tighter CDS spreads, while failing banks show strong drops in equity prices and widening CDS spreads. Interestingly, we also document strong market reactions at the announcement date of the stress tests. A bank's asset quality and its return on equity at the time of the announcement are significant predictors of the pass/fail outcome of a bank.

Do CDS Maturities Matter in the Evaluation of the Information Content of Regulatory Banking Stress Tests? Evidence from European and US Stress Tests

“…(equation 1) over a 120-trading days window (consistent with MacKinlay (1997) suggestion and following Alves et al, 2015;Flannery et al, 2017 andAhnert et al, 2018). Furthermore, since the stress testing exercises are generally performed each year (especially in the US), the choice of a 120-trading days estimation window allows us to prevent previous test events from influencing the estimation of the normal performance model parameters.…”

“…Following (among others) Flannery et al (2017) and Ahnert et al (2018), we will not consider as "event date" the stress test results' publication date but rather the next trading day. Indeed, the results are published either on a trading day but after market closing (in the US as in Europe), or during a non-trading day (as it was the case for the 2014 ECB-EBA stress test).…”

“…This latter is the return that would be expected if the event did not take place. To estimate it, following the recent stress test literature (Campbell et al, 2010;Morgan et al, 2014;Neretina et al, 2014;Flannery et al, 2017 andAhnert et al, 2018), we use a single-factor market model 7…”

“…Our research is motivated by the following. To estimate the CDS market response to a regulatory stress testing exercise (so to measure the impact and the informative value of a stress test), the literature almost systematically uses the 5-year maturity CDS spreads (among others, Morgan et al, 2014;Neretina et al, 2014;Flannery et al, 2017;Georgescu et al, 2017 andAhnert et al, 2018) since it is the most liquid segment of the market (Annaert et al, 2013;Völz & Wedow, 2011). However, is the maturity of fiveyear the one that best reflects the response of the CDS market?…”

“…Being the first to perform such empirical investigations, our paper attempts to contribute to the existing literature on regulatory banking stress tests, more precisely the literature on the impact, the information content and the effectiveness of stress tests (Petrella and Resti, 2013;Morgan et al, 2014;Neretina et al, 2014;Flannery et al, 2017;Georgescu et al, 2017 andAhnert et al, 2018). It attempts to further develop the understanding of the CDS market response to a stress testing exercise.…”