The Impact of Regulatory Stress Tests on Bank Lending and Its Macroeconomic Consequences 
The Dodd-Frank Act, enacted in 2010 in the wake of the Great Recession, introduced mandatory stress-testing for the largest US banks. Dodd-Frank Act Stress Testing (DFAST) was intended to ensure that banks have sufficient capitalization to absorb the losses they may experience in an economic downturn and continue providing credit to the economy. The stress-testing exercise, which is conducted by the Federal Reserve, uses hypothetical macroeconomic scenarios to predict a bank’s portfolio return under stress and its implied equity values. Thus, the exercise indicates whether a bank, given its current equity position and portfolio allocation, could withstand a severe economic downturn and maintain the credit supply to the economy.
This paper examines the impact DFAST has had on bank behavior. Specifically, it studies the effects of stress-testing on banks’ portfolio allocation, including the effects on financial stability risk, credit supply, and borrowers’ investment. The authors’ findings shed light on the broader macroeconomic consequences of bank behavior in response to DFAST.
Key Findings
- Since the inception of Dodd-Frank Act Stress-Testing (DFAST), the largest US banks have become more similar in terms of their overall asset allocation, and their commercial and industrial loan portfolios have become more similar in terms of borrower rating, industry, and geographic region.
- The portfolio similarity of banks subject to stress-testing has increased more than 5 percent between 2011 and 2016, on average, while the portfolio similarity of large banks not subject to stress-testing largely remained unchanged.
- Banks choose to hold relatively fewer assets that perform poorly under the stress-test scenario, while they increase their relative holding of assets that perform well in the stress test. This portfolio rebalancing leads to an increase in portfolio similarity and an increase in systemic concentration of banks.
- Loan-level data for banks subject to DFAST show that banks with poor stress-test results tend to have dissimilar portfolios before the test. However, after receiving the poor stress-test results, these banks tend to adjust their portfolios so that they more closely resemble those of banks with good DFAST results.
- Banks with poor stress-test results reduce loan supply along dimensions that perform poorly under the stress scenario, but those banks may not increase the supply of loans that perform well under the stress test. This portfolio rebalancing thus can lead to an overall reduction of credit supply relative to banks that don’t experience large stress-test losses.
- Borrowers with an ex ante higher reliance on banks that perform poorly in stress-testing are not able to substitute a loss in credit by increasing their borrowing from other large banks.
- A firm that borrows only from banks that perform poorly in the stress test faces a 14 percentage point greater decline in investment growth compared with a comparable firm that does not borrow from poorly performing banks.
Implications
While more diversified and well-capitalized banks in general result in lower bank-level risk, stress-testing has led to banks rebalancing their portfolios in ways that may inadvertently result in a build-up in systematic risk factors for the banking sector as a whole.
Furthermore, while the authors’ loan-level analysis confirms the desirable policy outcome of a credit supply reduction by banks in loans that add most to stress-test losses, the analysis also shows that this credit supply reduction can have real effects in the economy and lead to a decline in investment growth by firms that borrow from those banks and thus have adverse economic consequences.
Abstract
We use an expansive regulatory loan-level data set to analyze how the portfolios of the largest US banks have changed in response to the Dodd-Frank Act Stress Test (DFAST) requirements. We find that the portfolios of the largest banks, which are subject to stress-testing, have become more similar to each other since DFAST was implemented in 2011. We also find that banks with poor stress-test results tend to adjust their portfolios in a way that makes them more similar to the portfolios of banks that performed well in the stress-testing. In general, stress-testing has resulted in more diversified bank portfolios in terms of sectoral and regional composition. However, we also find that all the large banks diversified in a similar way, creating a more concentrated systemic portfolio in the aggregate. Finally, we analyze the effects of stress-testing and portfolio sensitivity to macroeconomic scenarios on credit supply. Our findings indicate that banks that experience worse results in the stress tests cut lending relative to their peers and specifically in loans that are most sensitive to the stress-test scenarios. At the borrower level, firms that rely more on credit from banks with poor stress-test results are not able to substitute lost funding and therefore face a larger reduction in credit and cut back investment. These results highlight a macroprudential effect of stress-testing: Credit growth is curtailed during a credit expansion in those banks holding a portfolio that is more sensitive to stressful scenarios. Hence, these banks are expected to be in a more resilient position at the onset of a downturn.