Fed Board, Report: Stressed Banks, Evidence from the Largest-Ever Supervisory Review

“Overall, results suggest that banks partly mask risk in supervisory audits, notably on liquid securities that are easier to trade (different from credit), with not only short-term spillovers on asset prices and credit supply, but also with medium-term implications for the real economy (corporate real effects). The results hold important implications for policy. In particular, the results carry policy implications for stress tests in particular, and for the design of supervision in general. The results suggest that pre-defining the timing and structure of a supervisory exercise incentivizes window-dressing behavior of banks, as it is optimal from a bank’s perspective (see e.g., Tarullo, 2014; Goldstein and Sapra, 2014; Coen, 2017). Thus, it might be necessary to have an element of surprise in the supervisory exercise, both with respect to the timing of the audits (either more continuous or random in time) and the degree of transparency over the specific process (i.e., methods and models used, and assets and type of risks assessed). The results also indicate that it is easier for banks to change the composition of liquid assets (securities trading) than illiquid ones (loans to firms). Thus, the results also point out that regulation of banks with substantial volume of marketable assets may pose significant challenges for supervision, with strong consequences for the overall economy. Finally, there are not just short-term but also medium-term negative spillovers for non-financial firm real effects (including firms with high productivity), thus highlighting some potential costs of banking supervision.”