Integrating Stress Tests within the Basel III Capital Framework: A Macroprudentially Coherent Approach

In the post-crisis era, banks’ capital adequacy is established by the Basel III capital standards and, in many jurisdictions, also by supervisory stress tests. In this article, we first describe the ways in which supervisory stress tests can supplement the risk-based capital framework of Basel III and how this could be codified with a stress test buffer. We then argue that in order to ensure coherence with the macroprudential objectives of Basel III, the severity of supervisory stress tests should be procyclical. In addition, to increase the transparency and predictability of the overall capital framework, severity choices should follow a constrained discretion approach based on a simple rule. Finally, we analyse supervisory stress testing practices across some jurisdictions and find that while in the USA and the UK they take into account some of our proposals, including most notably the need for procyclical severity, this is not the case in the euro area.