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

Abstract

The Basel committee views market discipline as complementing banking supervision. This paper studies how supervisors should design stress tests when markets discipline banks via price signals their traded securities provide to bank creditors. We show that the optimal stress test is coarse and lenient. Speculators have incentives to identify bad banks that erroneously passed the test, which makes markets useful at reducing the type-2, but not the type-1, error of a stress test. Our results hold even when the supervisor can intervene directly based on private information. In the limit of costless supervisory interventions, the optimal stress test is uninformative.