Lending Implications of U.S. Bank Stress Tests: Costs or Benefits?

TLDR: In this article, the authors formulate and test opposing hypotheses about the effect of bank credit supply in the U.S. bank stress tests and find that the results are consistent with the Risk Management Hypothesis, under which stress-tested banks reduce credit supply to decrease their credit risk.

Abstract: The U.S. bank stress tests aim to improve financial system stability. However, they may also affect bank credit supply. We formulate and test opposing hypotheses about these effects. Our findings are consistent with the Risk Management Hypothesis, under which stress-tested banks reduce credit supply – particularly to relatively risky borrowers – to decrease their credit risk. The findings do not support the Moral Hazard Hypothesis, in which these banks expand credit supply – particularly to relatively risky borrowers that pay high spreads – increasing their risk. Results are generally stronger for safer banks, banks that passed the stress tests, and the earlier stress tests.