Stress Testing Effects on Portfolio Similarities Among Large US Banks
In the wake of the 2008–2009 financial crisis, the United States enacted regulatory reforms designed to strengthen the country’s financial system. One new policy change, implemented in 2011, is the Dodd-Frank Act’s requirement that each of the largest banks operating in the United States—those with more than $50 billion in assets—undergo an annual stress test to examine the losses that might occur if there is a significant deterioration in economic conditions. After evaluating how an individual bank would fare under both an adverse and an extremely adverse scenario used in the stress testing exercises, those institutions that performed poorly on the tests, judged by having a high capital shortfall, then adjust their portfolios and reinforce their capital buffers. The goal of the stress tests is to make the largest US banks more resilient to shocks and default risk by proactively correcting for any weaknesses that are detected before a negative event actually occurs.
This paper examines how the behavior of major banks has changed in response to the stress testing requirements. While complementary studies have used stock market data to document an increased correlation in default probabilities and equity returns within the US banking industry since 2010, this paper uses the quarterly data on wholesale lending activities that banks report to the Federal Reserve to comply with supervisory requirements (the FR Y-14Q data collection). This loan-level data enables the authors to compare the largest banks based on several dimensions of their individual portfolios and to trace how these portfolios have changed over time.