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We focus our analysis on credit risk, which accounts for a large part of the stress testing projections and on average for 86% of risk exposure amounts in bank balance sheets. Less significant institutions (LSIs) were not tested and we therefore use them as the control group.2 The effect of supervisory scrutiny on credit risk In a second step, we compare credit risk of banks that were subject to a more intense supervisory scrutiny and banks that received less or none.1 The 2016 EU-wide stress test was executed on significant institutions (SIs). In a first step, we compare the credit risk of banks that were part of the stress test and banks that were not part of the stress test four quarters before and four quarters after the 2016 stress test. We apply a differences-in-differences approach where we use the stress test as a treatment and the involved scrutiny as a measure of the intensity of the treatment. Scrutiny measures the intensity of stress tests Source: Own illustration based on Mirza and Zochowski (2017). Intuitively, banks that received more flags had to work harder on their resubmissions and had lengthier and probably more intense interactions with supervisors while banks that received no flags in principle had no further interactions with supervisors.įigure 1 Simplified illustration of one quality assurance cycle under the constrained bottom-up approach We construct the scrutiny measure by counting the flags related to credit risk projections. Banks need to either comply with or explain the issues raised in the interactions with the ECB.
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In the presence of material deviations between these two sets of projections, ‘flags’ are triggered and are later discussed between supervisors and banks. Meanwhile, banks' projections are challenged by the competent supervisory authorities typically by applying top-down models and other challenger tools. In this context, banks use their own internal models to generate projections (e.g. These interactions arise as part of the constrained bottom-up approach pursued in the EBA-coordinated exercises (see Figure 1). We use data on these confidential interactions to approximate how much scrutiny was exerted on Single Supervisory Mechanism (SSM) banks under the direct supervision of the ECB during the 2016 EU-wide stress test.
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In Europe, stress tests involve interactions between banks and supervisors on banks' risk management practices as well as confidential communications about best stress-testing practices and techniques. How supervisory scrutiny is exerted in stress tests In the same vein, in a recent study, we show that higher supervisory scrutiny led to a disciplining effect for banks in the part of the European Banking Authority (EBA) EU-wide stress test conducted by the ECB in 2016. Recent evidence suggests that supervisory scrutiny decreases banks’ risk-taking activities (Rezende and Wu 2014, Hirtle et al. Stress tests offer deep insights into banks’ vulnerabilities to supervisors and the public through an intense supervisory process. Against this background, an important question is whether stress tests contribute to financial stability by promoting risk reduction in the banking sector, as recent evidence suggests (Cortes et al. Since the financial crisis, stress tests have become an important supervisory and financial stability tool (Constâncio 2017).