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July 1, 2021

Central Bank Research Hub

Limits of stress-test based bank regulation

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Originally published on by Bank of International Settlements . Link to original report

Supervisory risk assessment tools, such as stress-tests, provide complementary information about bank-specific risk exposures. Recent empirical evidence, however, underscores the potential inaccuracies inherent in such assessments. We develop a model to investigate the regulatory implications of these inaccuracies. In the absence of such tools, the regulator sets the same requirement across banks. Risk assessment tools provide a noisy signal about banks' types, and enable bank specific capital surcharges, which can improve welfare. Yet, a noisy assessment can distort banks' ex ante incentives and lead to riskier banks. The optimal surcharge is zero when assessment accuracy is below a certain threshold, and increases with accuracy otherwise.

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Bank for International Settlements BIS Working Papers by Tirupam Goel and Isha Agarwal

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