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.