The Effect of Comprehensive Capital Analysis and Review Stress Tests on Bank Risk

Abstract

Comprehensive Capital Analysis and Review (CCAR) stress tests are annual assessments run by the Federal Reserve to ensure large banks remain stable in financial crises. Even still, there have been a number of recent bank failures like the closure of Silicon Valley Bank and the collapse of Credit Suisse. Bank failures occurring after CCAR’s implementation raise questions towards the risk practices of large banks and the systems designed to regulate them. For this reason, this analysis explores whether CCAR stress tests succeed in reducing bank risk. Our research analyzes whether participating in CCAR stress tests lowers intrinsic bank risk measured in bank Z-score. We do so by using a Difference in Differences analysis with fixed effects. Empirical results find that banks transitioning into stress testing, continuing to stress test, and transitioning out of stress testing all have higher Z-scores and lower risk. This indicates that being stress tested and knowing of an upcoming stress test both encourage stringent risk policies and stable economic practices. The findings of this analysis motivate a policy recommendation for the creation of an annual random subsample for CCAR. Doing so would create a credible possibility of being stress tested, which could increase the effects of CCAR towards smaller regional entities it would have never otherwise considered.