Market Information in Banking Supervision: The Role of Stress Test Design

This paper studies the optimal degree of leniency in a bank stress test, when poorly capitalized banks engage in risk shifting and a banking supervisor can intervene to prevent it. The stress test directly provides the supervisor with noisy information about whether or not a bank is well capitalized. Furthermore, the stress test outcome a¤ects a speculator's incentives to acquire costly information about the bank and trade in its shares. This in turn a¤ects the amount of market information available to the supervisor when she takes her intervention decision. We show that a supervisor optimally distorts the stress test towards leniency for banks whose shares are relatively illiquid, and about whom the supervisor has little private information. When the supervisor has substantial private information about a bank whose shares are fairly liquid, it is optimal to apply a conservative stress test.